The Elusive Basis Problem of the Foreign Tax Credit Limitation

The Elusive Basis Problem of the Foreign Tax Credit Limitation

As we know, Congress tinkered with the foreign tax credit (FTC) rules in 2010 in a number of ways. One of those changes was to add Section 901(m) ("Denial of foreign tax credit with respect to foreign income not subject to United States taxation by reason of covered asset acquisitions") to the Code. (Education, Jobs and Medicaid Assistance Act, P.L. 111-226, § 212, HR 1586 (2010).

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The new provision applies to covered asset acquisitions occurring after December 31, 2010. The term "covered asset acquisitions" includes: (i) stock acquisitions for which an election under 26 USC § 338(g) has been made; (ii) any transaction that is treated as an asset acquisition for U.S. tax purposes, but a stock acquisition for foreign tax purposes; (iii) an acquisition of the interests in an entity treated as a partnership for U.S. tax purposes with respect to which an election under 26 USC § 754 has been made; (iv) any other similar transaction defined as such by the Treasury in the regulations. The new provision is not solely limited to direct asset acquisitions, but also extends its reach to indirect acquisitions (for example, an indirect acquisition of foreign assets owned by a U.S. company that is being acquired is also subject to the new limitation). In addition, the new provision does not distinguish between acquisitions of foreign assets from related or unrelated parties.

"Disqualified Portion." Not all of the foreign tax credit that the U.S. taxpayer is otherwise entitled to is disallowed; only the "disqualified portion" of foreign income tax is. The trick is to identify how much of the foreign tax is disqualified under the section. To do that, the taxpayer is to calculate the disallowed portion of the foreign tax credit through the use of a ratio. Specifically, the taxpayer is, each year, to determine the aggregate "basis differences" allocable to that year with respect to the relevant foreign assets. The taxpayer then divides the basis differences by the income on which the foreign income tax is determined to obtain the ratio (expressed as a percentage).

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Allocating the Basis Difference. The basis difference of any particular asset is to be allocated to taxable years using the applicable cost recovery method according to the Code...

Calculating the Disqualified Portion of the Foreign Tax Credit. The disqualified portion of any foreign income taxes is the percentage of the annual aggregate basis difference divided by the income (as determined per local law) from which the foreign tax was generated multiplied by the foreign tax.

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... [T]he significance of the new provision may be not so much in its direct application, but rather as a collateral effect of its application on transactions that are not driven by FTC considerations. Historically, taxpayers used the 26 USC § 338(g) election to treat a stock acquisition as an asset acquisition with the respective step-up in asset basis to avoid costly and burdensome due diligence efforts in identifying the asset basis of a foreign target for U.S. income tax purposes. With the new provision in effect, taxpayers now will be forced to evaluate the benefits of stepping up foreign assets basis versus structuring the acquisition in a manner that is not treated as a covered asset acquisition, thus avoiding the FTC basis difference rules. Absent further guidance, the administrative burden on taxpayers may be quite substantial.

Taxpayers acquiring foreign businesses or assets should consult their tax advisors to determine if the new provisions may limit otherwise available FTC and whether, alternatively, a deduction may be available with respect to such foreign income tax. Unfortunately, the deduction, while providing some relief, would not fully cure the problem created by the new provision.

In addition, taxpayers should keep their eyes on upcoming guidance from the Treasury and the Service that may provide some clarity with respect to several issues that the new provision carries with it.

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This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

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