Final regs. on partnership allocations of CFTEs.

• Author: Rollinson, Marjorie A.
• Position: Creditable foreign tax expenditures

The IRS issued final regulations (TD 9292, 10/19/06) under Sec. 704(b) that provide rules for the allocation of partnership creditable foreign taxes. They adopt the proposed and temporary regulations (TD 9121, 4/20/04), with substantial modifications.

Final Regs.

The final regulations retain the provisions of the proposed and temporary regulations excluding allocations of creditable foreign tax expenditures (CFTEs) from the substantial-economic-effect safe harbor of Regs. Sec. 1.704-1(b)(2), and provide a safe harbor under which allocations of CFTEs will be deemed to be in accordance with the partners' interests in the partnership (if CFTE allocations are in proportion to the distributive shares of income to which they relate). In comparison to the brief proposed and temporary regulations, the final regulations contain considerably more details, specifying the accounting for CFTEs and the income to which the tax expense relates.

Under the final regulations, the income to which a CFTE relates is the net income in the CFTE category to which the CFTE is allocated and apportioned. As discussed in more detail below, a CFTE category is a category of net income attributable to one or more partnership activities. The net income in a CFTE category is the net income determined for Federal income tax purposes attributable to each separate partnership activity included in the CFTE category. Income from separate activities is included in the same CFTE category only if the net income from such activities is allocated among the partners in the same proportions. Income from a divisible part of a single activity that is shared in a different ratio than other income from that activity is treated as income from a separate activity. (While the concept of allocating income from a "divisible part" is not defined in the regulations, it seems to refer simply to situations with a special allocation of income from a portion of an activity, such as a disregarded branch owned by a partnership.) CFTEs are allocated and apportioned to CFTE categories under Regs. Sec. 1.904-6 principles, as modified by the final regulations. Thus, CFTEs generally are allocated to a CFTE category if the income on which the CFTE is imposed (the net income recognized for foreign tax purposes) is in the CFTE category.

The final regulations include a three-step process for determining the distributive share of income to which a CFTE relates for purposes of the safe harbor. The partnership must (1) determine its CFTE categories; (2) determine the net income in each CFTE category; and (3) allocate and apportion CFTEs to the categories based on the net income in said categories. To satisfy the safe harbor, the partnership must allocate CFTEs among the partners in the same proportion as the allocations of net income in the applicable CFTE category.

CFTEs

The temporary and proposed regulations provided that a CFTE is a foreign tax paid or accrued by a partnership for a credit under Sec. 901(a). A qualifying domestic corporate shareholder may claim a credit under Sec. 901(a) for taxes paid or accrued by a foreign corporation and deemed paid by the shareholder under Sec. 902 or 960 on distribution or inclusion of the associated earnings. The final regulations clarify that a CFTE does not include foreign taxes deemed paid by a corporate partner under Sec. 902 or 960 (i.e., on distributions received by a partnership that are dividends for U.S. tax purposes). The final regulations also clarify that they do not apply to foreign taxes paid or accrued by a partner (foreign taxes for which the partner--as distinguished from the partnership itself--has legal liability within the meaning of Regs. Sec. 1.901-2(f)). Further, a CFTE does include a foreign tax paid or accrued by a partnership eligible for a credit under an applicable U.S. income tax treaty.

Categories: Examples in the temporary and proposed regulations illustrated that the determination of the income to which a CFTE relates must be made separately for certain income categories when the partnership agreement provides for different allocations of such income. The final regulations provide additional guidance that is also intended to assist in determining the distributive share of income to which a foreign tax relates.

The relevant category of income is the CFTE category, defined in the final regulations as net income, computed for U.S. purposes, attributable to one or more partnership activities. The final regulations generally provide that net income from all of the partnership's activities is treated as income in a single CFTE category. The general rule does not apply, however, if the partnership agreement provides for an allocation of net income from one or more activities that differs from the allocation of net income from other activities. In that case, net income from each activity or group of activities subject to a different allocation is treated as net income in a separate CFTE category. For this purpose, income from a divisible part of a single activity is treated as income from a separate activity if such income is shared in a different ratio than other income from the activity.

Thus, if a partnership agreement allocates all partnership items in the same manner, the partnership will have a single CFTE category, regardless of the number of activities in which it is engaged. Conversely, a partnership agreement that provides for different allocations of net income with respect to one or more activities will have multiple CFTE categories. Different allocations of the partnership's net income from separate activities and, thus, multiple CFTE categories, may result if the partnership agreement contains special allocations.

Under the final regulations, whether the partnership has different sharing ratios for income from one or more activities (and, thus, has more than one CFTE category) must be determined in a reasonable manner, taking into account all the facts and circumstances. In evaluating whether aggregating or disaggregating income from particular business or investment operations is a reasonable method of determining an activity's scope, the principal consideration is whether the proposed determination has the effect of separating CFTEs from the related foreign income. Relevant facts and circumstances include whether the partnership conducts business or investment operations in...