Introduction

Among the many international changes wrought by the TCJA was the addition of a separate Code Sec. 904(d) basket for income attributable to one or more branches of a U.S. person. The final foreign tax credit regulations issued in December 2019 (hereafter, the "3")1 provide new and definitive guidance on the branch basket. Attribution of income to a foreign branch is a new, but not unprecedented problem in U.S. international tax. Previously, many U.S. outbound taxpayers engaged in similar exercises for purposes of the dual consolidated loss ("DCL") rules of Code Sec. 1503(d), currency translation rules under Code Sec. 987, and Code Sec. 367 branch loss recapture, among other purposes. The attribution of income to the foreign branch category under Code Sec. 904 will follow a different and equally complex approach to Code Sec. 987. In this regard, the Final Regulations largely follow the 2018 proposed regulations2 in their treatment of disregarded transactions between the branch and its sole owner, or between branches of the same U.S. taxpayer, with limited relief for certain transfers of IP. To limit cross-crediting, the Final Regulations also exclude not only passive income, but also intercompany financing and other low-taxed income from the branch basket

Prior to the TCJA, branches with significant foreign tax expense were the exception not the rule for most U.S. multinational corporations. However, after the TCJA, more U.S. corporations have checked the box on their foreign subsidiaries for several reasons, including managing the base erosion antiabuse tax ("BEAT") on outbound payments or facilitating the movement of IP back to the United States. Corporate taxpayers may also find themselves with foreign branches by having "checked the box" on a newly acquired foreign target company following a qualified stock purchase with a Code Sec. 338(g) election. In addition, foreign operations of partnerships, S corporations and other passthrough entities will often be organized as branches to enable U.S. individual owners to claim direct foreign tax credits under Code Sec. 901. These taxpayers will need to wrestle with computations of branch basket income.

Identification of a Foreign Branch

Code Sec. 904(d)(2)(J) defines a "foreign branch" as any "qualified business unit" of a U.S. person as defined under the foreign currency rules—i.e., Code Sec. 989. Accordingly, a controlled foreign corporation ("CFC") or other foreign entity cannot have income in the branch basket. As to the U.S. taxpayer, the branch basket generally is computed on an aggregate basis across all "branches,"3 so that cross crediting of income and taxes of different branches is generally possible. While the branch basket is computed on an aggregate basis, a branch that provides goods or services to its U.S. owner may be allocated U.S. source income under the disregarded payment rules that are discussed below, and as a result, the U.S. owner may need to rely on an income tax treaty to claim foreign tax credits. As discussed in more detail below, the treaty basket is applied on a per country basis.4

Following the Proposed Regulations, the Final Regulations require that a "foreign branch" constitute a trade or business outside of the United States.5 Thus, disregarded entities involved solely in financing or equity holding activities may not constitute a "foreign branch" for Code Sec. 904 purposes.6 However, activities of a taxpayer that constitute a permanent establishment under an applicable income tax treaty are treated as a foreign branch.7 The mere presence of a disregarded entity with separate books and records does not give rise to a foreign branch for purposes of Code Sec. 904. Also, a foreign trade or business of a corporation, partnership, estate or trust will be treated as a branch even if it does not maintain a separate set of books and records.8

In the case of a foreign branch held through a passthrough entity, the Final Regulations adopt a flat approach. In the case of a tiered set of disregarded entities, each disregarded entity's foreign branch is treated as if it were owned directly by the ultimate U.S. owner.9 Branch category income also includes a distributive share of income from a partnership or other passthrough entity from its foreign branches.10 Thus, U.S. individuals who indirectly own foreign entities through a passthrough structure will be subject to the separate Code Sec. 904(d) category for branch income.

Attribution of Income to a Branch

As under the Proposed Regulations, the starting point for computing the gross income attributable to a foreign branch is the gross income reflected on its books and records, as adjusted to conform to U.S. tax principles.11 Under this basic rule, a taxpayer with a branch that operates as a standalone, fully integrated business can readily compute branch income. Life, however, is rarely so simple. The existence of intercompany transactions between branches or between the branch and its owner will give rise to major complexity, as discussed below.

3Foreign branches of the taxpayer are likely to be hightaxed entities. Many taxpayers may find themselves in an excess credit position in the branch basket and seek to increase their Code Sec. 904 limitation on branch income. Although the statute only excludes "passive basket income" from the branch basket,12 the Final Regulations expand this exclusion to other income that might be a source of low-taxed income in a foreign branch. Adjustments are made to remove income from investment-type activities, such as income from the branch's ownership of stock.13 Under an anti-abuse rule for income booked in (or outside) a branch with a principal purpose of reducing U.S. tax, interest income received from related persons is also excluded from branch income unless it falls within the financial services basket for Code Sec. 904. This would seem aggressive rulemaking to deem any location of financing transactions abusive. For example, if the taxpayer chooses to locate an intercompany loan from a CFC in a branch, why shouldn't this reasonable business and booking practice be respected? Due to look-through rules under Code Sec. 904(d) and Code Sec. 954(c)(6), taxpayers are generally able to cross credit low-taxed interest income against high-taxed income in the general or global intangible low-taxed income ("GILTI") baskets. There would not seem to be a principled reason to prohibit financing income from being attributed to the branch basket if it is earned in a foreign branch of the taxpayer. However, under the Final Regulations, locating an intercompany receivable in a foreign branch would be per se an improper booking practice.14

In addition, the Final Regulations like the Proposed Regulations do not "push down" gain from the sale of an interest in a foreign disregarded entity (FDE) (or partnership) to the branch basket, unless the sale of the interest is made by the branch in the ordinary course of business.15 The sale is deemed to occur in the ordinary course of business only if the transferred branch and the branch making the sale are engaged in the same or a related trade or business.16 Such gain would otherwise typically default to the general basket. The source of that gain would depend on the residency of the seller and other applicable rules of Code Sec. 865.

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Footnotes

1. T.D. 9882 (Dec. 16, 2019).

2. Notice of Proposed Rulemaking REG-105600- 18 (Dec. 7, 2018) (hereafter, the "Proposed Regulations").

3. See Code Sec. 904(d)(2)(J)(i) (defining the category as the income attributable to "1 or more qualified business units ... in 1 or more foreign countries") (emphasis added).

4. Reg. §1.904-4(k).

5. Reg. §1.904-4(f)(3)(vii)(A).

6. See Reg. §1.987-1(b)(7), Example 1.

7. Reg. §1.904-4(f)(3)(vii)(B).

8. Reg. §1.904-4(f)(3)(vii)(C). In the case of a foreign branch that does not maintain separate books and records, the taxpayer would have to reconstruct books and records of the foreign branch under the principles of the ECI rules. See id. (directing the taxpayer to apply Reg. §1.1503(d)-5/(c)).

9. Reg. §1.904-4(f)(3)(viii).

10. Reg. §1.904-4(f)(1)(i)(B).

11. Reg. §1.904-4(f)(2)(i).

12. Code Sec. 904(d)(2)(J)(ii).

13. Reg. §1.904-4(f)(2)(iii)(A).

14. An exception to this rule is provided for a branch that is a financial services entity, in recognition of the fact that interest in the hands of such an entity is business income. See Reg. §1.904-4(f)(2)(v).

15. Reg. §1.904-4(f)(2)(iv). Compare the approach taken for determining the Code Sec. 960 category of a CFC's taxes on a sale of a disregarded entity, whereby taxes imposed on the sale of a foreign disregarded entity are characterized by reference to the assets held by the disregarded entity. See Proposed Reg. §1.861- 20(g)(12), Example 11.

16. Reg. §1.904-4(f)(2)(iv)(B)(1) & (2).

Originally published in the January – February 2020 issue of the International Tax Journal.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.