On March 20, 2020, Treasury and the IRS released final regulations under Section 901(m). The regulations were published in the Federal Register on March 23, and generally apply to covered asset acquisitions (CAAs) occurring on or after that date. However, the rules codifying the "disposition" and "successor" rules announced in Notice 2014-44 (and Notice 2014-45) are retroactive to the July 2014 effective dates announced in the notices.
The final regulations implement the specific rules originally announced in Notice 2014‑44, as well as the more comprehensive rules from the December 2016 proposed regulations, without substantial change.
Section 901(m) denies a foreign tax credit for the "disqualified portion" of any foreign income tax following a CAA. The disqualified portion of the foreign income tax is intended to only permit crediting of the same proportion of the foreign income tax equal to the ratio of the target's U.S. taxable income to its foreign taxable income. In a CAA, the U.S. or CFC acquirer obtains a stepped‑up basis in the foreign target's assets for U.S. tax purposes, typically without a corresponding basis step-up for foreign income tax purposes. Thus, the U.S. taxable income is typically less than the foreign taxable income, due to increased depreciation or amortization, for example.
Covered Asset Acquisitions
The final regulations generally retain the six types of CAA set forth in the proposed regulations. In summary, the six CAAs are: (1) a qualified stock purchase to which Section 338 applies; (2) any transaction treated as an asset acquisition for U.S. tax purposes and treated as a stock acquisition (or disregarded) for foreign tax purposes; (3) any acquisition of a partnership with a Section 754 election in effect; (4) any transaction (or series of transactions under a plan) to the extent it is treated as an asset acquisition for U.S. tax purposes and as the acquisition of an interest in a fiscally transparent entity for foreign tax purposes; (5) any transaction (or series of transactions under a plan) to the extent treated as a partnership distribution of one or more assets the U.S. basis of which is determined by Section 732(b) or 732(d) or to the extent it causes the U.S. basis of the partnership's remaining assets to be adjusted under Section 734(b), provided the transaction results in an increase in the U.S. basis of one or more of the distributed or retained assets without a corresponding increase in the foreign basis of such assets; and (6) any transaction (or series of transactions under a plan) to the extent it is treated as an asset acquisition for both U.S. tax and a foreign tax, provided the transaction results in an increase in the U.S. basis without a corresponding increase in the foreign basis of one or more assets.
One modification is that the final regulations exempt Section 901(m) from applying if a domestic Section 901(m) payor or member of its consolidated group recognizes gains and losses (either directly or via a partnership allocation) with respect to the relevant foreign assets (RFAs). The regulations implement this rule by modifying the definition of aggregate basis difference (ABD) to take into account allocated basis difference adjustments determined based on gain or loss recognized with respect to an RFA as a result of a CAA. For example, if one member of a consolidated group sells a foreign disregarded entity to another member of the consolidated group, the ABD determined by the purchasing member with respect to the RFA is adjusted to take into account the gain recognized by the selling member, provided the members continue to be part of the same consolidated group in the year the ABD is determined.
Otherwise, Treasury and the IRS did not accept comments that the categories of CAAs were overbroad. The preamble states that Treasury and the IRS view Section 901(m) as a more or less mechanical rule that is not based on taxpayer intent. Rather, according to the preamble, Section 901(m) should generally apply to any transactions that result in a basis difference for U.S. and foreign income tax purposes.
ABD Carryover, Disposition and Successor Rules Retained
Under the statutory formula in Section 901(m)(3), the disqualified portion of foreign income taxes is computed by multiplying the foreign income taxes for the year by the fraction that is equal to the ABD allocated to the year over the foreign income for the year. For example, assume that the ABD for the year equals $10x, and the CFC earns $20x of foreign income subject to 30% foreign tax rate. Before applying Section 901(m), the CFC would have $4x of income and $6x of foreign tax. Section 901(m) would disallow 50% of the $3x foreign tax as a credit (i.e., $6x of tax for the year x $10x ABD/$20x foreign income).
The statutory formula does not in itself address timing differences in the imposition of U.S. and foreign tax. For example, assume the CFC above instead had a <$10x> NOL for local tax purposes and an additional $10x of amortization for U.S. tax purposes only. The $10x of ABD recovered in the year would not seem to result in any disqualification of taxes, because there are no foreign income taxes in the year that the ABD is recovered.
The proposed regulations introduced and the final regulations retain a complex "ABD carryover" rule to account for such timing mismatches and ensure that Section 901(m)'s disqualification fully applies. See Reg. § 1.901(m)-3(c). Specifically, under the final regulations, where the disqualified tax amount under Section 901(m) is zero, the entire ABD becomes an ABD carryover to a later year. An ABD carryover can also arise to the extent the ABD for a year exceeds the foreign income for the taxable year. In either case, the ABD will carry over and compound the Section 901(m) disallowance in a later year when foreign taxes are taken into account.
The Final Regulations also retain rules originally announced in Notice 2014-44 that (1) limit the amount of ABD taken into account on "dispositions" that are not fully taxable for both U.S. and foreign tax purposes, and (2) continue to apply the Section 901(m) "taint" to "successors" that acquire the relevant foreign assets. For partnership transactions, changes were made to the successor rules to coordinate with Section 704(c). The "disposition" and "successor" rules are generally retroactive to the July 2014 date of the notice.
Foreign Basis Election
The final regulations also retain the taxpayer-favorable "Foreign Basis Election" for determining the basis difference under Section 901(m). Under the Code, the ABD is equal to the difference between the U.S. tax basis in the relevant assets before the CAA and the U.S. tax basis after the CAA. In lieu of using the U.S. basis before the CAA for comparison, the Foreign Basis Election would allow the taxpayer to compare the U.S. basis after the CAA with the foreign tax basis after the CAA. Such election can be made separately for each CAA of the taxpayer.
The Foreign Basis Election may be helpful to the taxpayer in at least two respects. First, in many cases, U.S. tax basis before the CAA may not be readily ascertainable for the target entity. Using foreign tax basis as the point of comparison will be much more administrable than attempting to reconstruct U.S. tax basis in the assets of an entity that may never have been relevant for U.S. tax purposes before. Second, certain jurisdictions provide a local tax election to step up the basis of goodwill or other assets as a result of a stock purchase. In the case of a taxpayer making such an election to bump up local tax basis, the Foreign Basis Election avoids an otherwise punitive result under Section 901(m).
The final regulations, like the proposed regulations, allow the taxpayer to elect to make the Foreign Basis Election retroactively, but only if the proposed regulations are applied retroactively in their entirety to all open taxable years. In addition, where the early adoption to the Foreign Basis Election would result in a refund in an open year, but other provisions of the regulations would result in a deficiency in a closed year, the taxpayer must net the deficiency against the refund in the open year.
De Minimis Exception
The de minimis exceptions from the final regulations are liberalized slightly from the proposed regulations. The proposed regulations included two de minimis exceptions from Section 901(m): an overall exception, where the total ABD in the CAA does not exceed the lesser of $10 million or 10% of the total U.S. tax basis in the assets; and a class-based exception, where the total ABD in one of the Section 1060 asset classes does not exceed the lesser of $2 million or 10% of total U.S. tax basis in that class of assets.
The final regulations retain the same basic thresholds. However, an additional exception applies to an individual RFA where the basis difference with respect to that asset is less than $20,000. Also, the final regulations remove the lower de minimis thresholds for related-party CAA transactions. Related party transactions are now subject to the same de minimis thresholds. As in the proposed regulations, multiple related CAAs undertaken as part of the same plan must be considered in the aggregate in testing the de minimis exceptions.
Overlap with Section 909
The final regulations add a priority rule where Sections 901 and 909 overlap. One such example of an overlap is the acquisition of a reverse hybrid with respect to which a Section 338 election is made. In such a case, the acquisition is a Section 901(m) CAA, and the reverse hybrid structure is a Section 909 foreign tax credit splitter.
The priority rule provides that the Section 901(m) calculations are performed before applying Section 909. In addition, the final regulations provide that all foreign taxes, and not only those foreign taxes disqualified under Section 901(m), are subject to potential suspension under Section 909. In the Preamble Treasury and the Service state that foreign taxes disqualified for foreign tax credit purposes under Section 901(m) but remain eligible to be deducted may be subject to deferral under Section 909 as well.
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