Allocating foreign taxes: IRS rules that partnerships must allocate foreign taxes in proportion to foreign income.

• Author: Graham, Michael
• Position: FederalTax

The IRS recently issued temporary regulations requiring partnerships to allocate foreign taxes in the same way that they allocate the income to which those taxes relate.

The temporary regulations are targeting transactions in which U.S. partners, or U.S. shareholders of partners that are controlled foreign corporations, attempt--through special partnership allocations--to claim foreign tax credits not matched by income subject to U.S. taxation (T.D. 9121, Reg.-139792-02).

The new regulations seek to disqualify taxpayers' inappropriate foreign tax credit applications and the IRS wants to ease its concerns about partnerships allocating foreign tax credits without allocating the corresponding income.

The IRS argues that allocations by foreign tax partnerships without corresponding income do not give rise to the double taxation that is the economic basis for the foreign tax credit, and that these types of allocations should not be allowed.

Temporary Regulations Establish Safe Harbor

The temporary regulations establish a safe harbor rule under which allocations of foreign tax expenditures will be deemed in accordance with each partner's interests in the partnership.

Under this rule, if the partnership satisfies the requirements of Sec. 1.704-1(b)(2)(ii)(b) or (d)--i.e., capital account maintenance; liquidation according to capital accounts; and either deficit restoration obligations or qualified income offsets--then an allocation of a foreign tax expenditure proportionate to a partner's distributive share of the partnership income to which such taxes relate, including income allocated pursuant to section 704(c), will be deemed in accordance with the partner's interest in the partnership.

The IRS says the rule is consistent with the intent of both the foreign tax credit, which is to avoid double taxation of foreign income, and the foreign tax credit limitation, which was written to prevent foreign tax credits from offsetting tax liability on U.S. income.

Also, this rule achieves better parity between entities taxed under foreign law at the partner level and entities taxed under foreign law at the entity level.

If a partnership were taxed under foreign law at the partner level, then the amount of foreign taxes imposed would be in proportion to the partner's share of income subject to the foreign tax.

The partner would take this amount of foreign tax into account when computing U.S. tax liability.

Similarly, for partnerships taxed under foreign law...