Allocation of Creditable Foreign Taxes, 35539-35545 [2019-15362]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 84, Number 142 (Wednesday, July 24, 2019)]
[Rules and Regulations]
[Pages 35539-35545]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-15362]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9871]
RIN 1545-BM56


Allocation of Creditable Foreign Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final regulations with respect to a 
provision of the Internal Revenue Code (Code) that addresses the 
allocation by a partnership of foreign income taxes. These regulations 
are necessary to improve the operation of an existing safe harbor rule 
that determines whether allocations of creditable foreign tax 
expenditures are deemed to be in accordance with the partners' 
interests in the partnership. The regulations affect partnerships that 
pay or accrue foreign income taxes and partners in such partnerships.

DATES: 
    Effective date: These regulations are effective on July 24, 2019.
    Applicability dates: For dates of applicability, see Sec.  1.704-
1(b)(1)(ii)(b)(1).

FOR FURTHER INFORMATION CONTACT: Suzanne M. Walsh, (202) 317-6936 (not 
a toll-free call).

SUPPLEMENTARY INFORMATION: 

Background

    On February 4, 2016, a notice of proposed rulemaking by cross-
reference to temporary regulations (REG-100861-15) under section 704 of 
the Code and temporary regulations (T.D. 9748) (2016 temporary 
regulations) were published in the Federal Register at 81 FR 5966 and 
81 FR 5908, respectively.
    Section 1.704-1(b)(4)(viii) provides a safe harbor under which 
allocations of creditable foreign tax expenditures (``CFTEs'') are 
deemed to be in accordance with the partners' interests in the 
partnership. The 2016 temporary regulations revised the rules under 
this section to clarify the effect of section 743(b) adjustments on the 
determination of net income in a CFTE category. The 2016 temporary 
regulations also include special rules regarding how deductible 
allocations and nondeductible guaranteed payments (that is, allocations 
that give rise to a deduction under foreign law, and guaranteed 
payments that do not give rise to a deduction under foreign law) are 
taken into account for purposes of determining net income in a CFTE 
category. Finally, the 2016 temporary regulations include a 
clarification of the rules regarding the treatment of disregarded 
payments between branches of a partnership for purposes of determining 
income attributable to an activity included in a CFTE category.
    A public hearing was not requested and none was held. However, the 
Department of the Treasury (``Treasury Department'') and the Internal 
Revenue Service (``IRS'') received a written comment in response to the 
notice of proposed rulemaking. After consideration of the comment, the 
proposed regulations under section 704 are adopted as amended by this 
Treasury decision. The revisions are discussed in this preamble.

Explanation of Revisions and Summary of Comments

    The comment requested revising the regulations to provide that 
disregarded payments between CFTE categories are taken into account in 
computing the net income in a CFTE category. The comment argued that 
the placement of a disregarded payment rule in a paragraph that 
discusses attribution of income to an activity is potentially confusing 
and requested that the language be moved to the portion of the 
regulation that addresses the basic definition of activities and that 
in its place a statement be added providing that disregarded payments 
between CFTE categories will reduce net income

[[Page 35540]]

in one CFTE category and increase net income in the other category.
    The Treasury Department and the IRS have determined the rule is 
clear as originally drafted in the 2016 temporary regulations. Income 
in a CFTE category is determined first by assigning items of income to 
activities. Activities are then grouped together in a CFTE category to 
the extent the income attributable to activities is allocated using the 
same allocation percentages. Section 1.704-1(b)(4)(viii)(c)(3). 
Disregarded payments are not taken into account in determining income 
assigned to an activity. However, if a partnership makes allocations to 
give economic regard to the disregarded payment, it can result in more 
than one allocation percentage being applied to income within the same 
activity. Section 1.704-1(b)(4)(viii)(c)(3)(iv). This will result in 
the activity being subdivided and the subdivided portions being 
assigned to different CFTE categories. See Example 24 in Sec.  1.704-
1(b)(5)(xxiv). In other words, while the 2016 temporary regulations do 
not literally provide that a disregarded payment ``reduces'' the net 
income in a CFTE category in that case, the 2016 temporary regulations 
provide for a result similar to the result suggested by the comment by 
instead subdividing an activity and then assigning one sub-activity to 
a different CFTE category. This approach is more consistent with the 
fact that income items are determined based on regarded items and not 
disregarded items, including disregarded payments. These final 
regulations add a cross reference to the disregarded payment rule for 
assigning income to an activity in Sec.  1.704-1(b)(4)(viii)(c)(3)(iv) 
in the paragraph that provides the basic definition of an activity to 
further highlight the interaction of those two paragraphs. See Sec.  
1.704-1(b)(4)(viii)(c)(2)(iii).
    The 2016 temporary regulations unintentionally deleted Sec.  1.704-
1(b)(4)(viii)(d)(1)(i) and (ii). Those paragraphs are restored without 
change by these regulations. In order to comply with new Federal 
Register formatting requirements, Examples 25, 36 and 37 in Sec.  
1.704-1T(b)(5) in the 2016 temporary regulations appear without further 
changes in Sec.  1.704-1(b)(6)(i) through (iii) of these final 
regulations, Examples 1, 2, and 3, respectively.

Special Analyses

    This regulation is not subject to review under section 6(b) of 
Executive Order 12866 pursuant to the Memorandum of Agreement (April 
11, 2018) between the Treasury Department and the Office of Management 
and Budget regarding review of tax regulations. Therefore, a regulatory 
impact assessment is not required. Because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f), the proposed rule preceding these final regulations 
was submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business and no 
comments were received.

Drafting Information

    The principal author of these regulations is Suzanne M. Walsh of 
the Office of Associate Chief Counsel (International). However, other 
personnel from the IRS and the Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *


0
Par. 2. Section 1.704-1 is amended as follows:
0
1. In paragraph (b)(0):
0
i. Add a heading for the table.
0
ii. Revise the entries for Sec.  1.704-1(b)(1)(ii)(b)(1), 
(b)(4)(viii)(c)(1) through (4), and (b)(4)(viii)(d)(1) and add an entry 
for Sec.  1.704-1(b)(6) at the end of the table.
0
2. Revise paragraph (b)(1)(ii)(b)(1).
0
3. Redesignate paragraphs (b)(1)(ii)(b)(3)(A) and (B) as paragraphs 
(b)(1)(ii)(b)(3)(i) and (ii), respectively.
0
4. Revise newly redesignated paragraph (b)(1)(ii)(b)(3)(ii) and 
paragraphs (b)(4)(viii)(a)(1), (b)(4)(viii)(c)(1), 
(b)(4)(viii)(c)(2)(ii) and (iii), (b)(4)(viii)(c)(3) and (4), and 
(b)(4)(viii)(d)(1).
0
5. Add paragraph (b)(6).
    The revisions and additions read as follows:


Sec.  1.704-1   Partner's distributive share.

* * * * *
    (b) * * *
    (0) * * *

                       Table 1 to Paragraph (b)(0)
------------------------------------------------------------------------
            Heading                              Section
------------------------------------------------------------------------
 
                              * * * * * * *
In general.....................  1.704-1(b)(1)(ii)(b)(1)
 
                              * * * * * * *
In general.....................  1.704-1(b)(4)(viii)(c)(1)
CFTE category..................  1.704-1(b)(4)(viii)(c)(2)
Net income in a CFTE category..  1.704-1(b)(4)(viii)(c)(3)
CFTE category share of income..  1.704-1(b)(4)(viii)(c)(4)
 
                              * * * * * * *
In general.....................  1.704-1(b)(4)(viii)(d)(1)
 
                              * * * * * * *
Examples.......................  1.704-1(b)(6)
------------------------------------------------------------------------

    (1) * * *
    (ii) * * *
    (b) * * *
    (1) In general. Except as otherwise provided in this paragraph 
(b)(1)(ii)(b)(1), the provisions of paragraphs (b)(3)(iv) and 
(b)(4)(viii) of this section (regarding the allocation of creditable 
foreign taxes) apply for partnership taxable years beginning on or 
after October 19, 2006. The rules that apply to allocations of 
creditable foreign taxes made in partnership taxable years

[[Page 35541]]

beginning before October 19, 2006 are contained in Sec.  1.704-
1T(b)(1)(ii)(b)(1) and (b)(4)(xi) as in effect before October 19, 2006 
(see 26 CFR part 1 revised as of April 1, 2005). However, taxpayers may 
rely on the provisions of paragraphs (b)(3)(iv) and (b)(4)(viii) of 
this section for partnership taxable years beginning on or after April 
21, 2004. The provisions of paragraphs (b)(4)(viii)(a)(1), 
(b)(4)(viii)(c)(1), (b)(4)(viii)(c)(2)(ii) and (iii), 
(b)(4)(viii)(c)(3) and (4), (b)(4)(viii)(d)(1), and Examples 1, 2, and 
3 in paragraphs (b)(6)(i), (ii), and (iii) of this section apply for 
partnership taxable years that both begin on or after January 1, 2016, 
and end after February 4, 2016. For the rules that apply to partnership 
taxable years beginning on or after October 19, 2006, and before 
January 1, 2016, and to taxable years that both begin on or after 
January 1, 2016, and end on or before February 4, 2016, see Sec.  
1.704-1(b)(1)(ii)(b), (b)(4)(viii)(a)(1), (b)(4)(viii)(c)(1), 
(b)(4)(viii)(c)(2)(ii) and (iii), (b)(4)(viii)(c)(3) and (4), 
(b)(4)(viii)(d)(1), and (b)(5), Example 25 (as contained in 26 CFR part 
1 revised as of April 1, 2015).
* * * * *
    (3) * * *
    (ii) Transition rule. Transition relief is provided by this 
paragraph (b)(1)(ii)(b)(3)(ii) to partnerships whose agreements were 
entered into before February 14, 2012. In such cases, if there has been 
no material modification to the partnership agreement on or after 
February 14, 2012, then, for taxable years beginning on or after 
January 1, 2012, and before January 1, 2016, and for taxable years that 
both begin on or after January 1, 2012, and end on or before February 
4, 2016, these partnerships may apply the provisions of Sec.  1.704-
1(b)(4)(viii)(c)(3)(ii) and (b)(4)(viii)(d)(3) (see 26 CFR part 1 
revised as of April 1, 2011). For taxable years that both begin on or 
after January 1, 2016, and end after February 4, 2016, these 
partnerships may apply the provisions of Sec.  1.704-
1(b)(4)(viii)(d)(3) (see 26 CFR part 1 revised as of April 1, 2011). 
For purposes of this paragraph (b)(1)(ii)(b)(3), any change in 
ownership constitutes a material modification to the partnership 
agreement. The transition rule in this paragraph (b)(1)(ii)(b)(3)(ii) 
does not apply to any taxable year in which persons bearing a 
relationship to each other that is specified in section 267(b) or 
section 707(b) collectively have the power to amend the partnership 
agreement without the consent of any unrelated party (and all 
subsequent taxable years).
* * * * *
    (4) * * *
    (viii) * * *
    (a) * * *
    (1) The CFTE is allocated (whether or not pursuant to an express 
provision in the partnership agreement) to each partner and reported on 
the partnership return in proportion to the partners' CFTE category 
shares of income to which the CFTE relates; and
* * * * *
    (c) Income to which CFTEs relate--(1) In general. For purposes of 
paragraph (b)(4)(viii)(a) of this section, CFTEs are related to net 
income in the partnership's CFTE category or categories to which the 
CFTE is allocated and apportioned in accordance with the rules of 
paragraph (b)(4)(viii)(d) of this section. Paragraph (b)(4)(viii)(c)(2) 
of this section provides rules for determining a partnership's CFTE 
categories. Paragraph (b)(4)(viii)(c)(3) of this section provides rules 
for determining the net income in each CFTE category. Paragraph 
(b)(4)(viii)(c)(4) of this section provides rules for determining a 
partner's CFTE category share of income, including rules that require 
adjustments to net income in a CFTE category for purposes of 
determining the partners' CFTE category share of income with respect to 
certain CFTEs. Paragraph (b)(4)(viii)(c)(5) of this section provides a 
special rule for allocating CFTEs when a partnership has no net income 
in a CFTE category.
    (2) * * *
    (ii) Different allocations. Different allocations of net income (or 
loss) generally will result from provisions of the partnership 
agreement providing for different sharing ratios for net income (or 
loss) from separate activities. Different allocations of net income (or 
loss) from separate activities generally will also result if any 
partnership item is shared in a different ratio than any other 
partnership item. A guaranteed payment described in paragraph 
(b)(4)(viii)(c)(4)(ii) of this section, gross income allocation, or 
other preferential allocation will result in different allocations of 
net income (or loss) from separate activities only if the amount of the 
payment or the allocation is determined by reference to income from 
less than all of the partnership's activities.
    (iii) Activity. Whether a partnership has one or more activities, 
and the scope of each activity, is 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 constitutes a reasonable method of determining 
the scope of an activity, the principal consideration is whether the 
proposed determination has the effect of separating CFTEs from the 
related foreign income. Relevant considerations include whether the 
partnership conducts business in more than one geographic location or 
through more than one entity or branch, and whether certain types of 
income are exempt from foreign tax or subject to preferential foreign 
tax treatment. In addition, income from a divisible part of a single 
activity is treated as income from a separate activity if necessary to 
prevent separating CFTEs from the related foreign income, such as when 
income from divisible parts of a single activity is subject to 
different allocations. See, for example, paragraph 
(b)(4)(viii)(c)(3)(iv) of this section (special allocations related to 
disregarded payments can give rise to subdivision of an activity into 
divisible parts). A guaranteed payment, gross income allocation, or 
other preferential allocation of income that is determined by reference 
to all the income from a single activity generally will not result in 
the division of an activity into divisible parts. See Example 22 in 
paragraph (b)(5)(xxii) of this section and Example 1 in paragraph 
(b)(6)(i) of this section. The partnership's activities must be 
determined consistently from year to year absent a material change in 
facts and circumstances.
    (3) Net income in a CFTE category--(i) In general. A partnership 
computes net income in a CFTE category as follows: First, the 
partnership determines for U.S. Federal income tax purposes all of its 
partnership items, including items of gross income, gain, loss, 
deduction, and expense, and items allocated pursuant to section 704(c). 
For the purpose of this paragraph (b)(4)(viii)(c)(3)(i), the items of 
the partnership are determined without regard to any adjustments under 
section 743(b) that its partners may have to the basis of property of 
the partnership. However, if the partnership is a transferee partner 
that has a basis adjustment under section 743(b) in its capacity as a 
direct or indirect partner in a lower-tier partnership, the partnership 
does take such basis adjustment into account. Second, the partnership 
must assign those partnership items to its activities pursuant to 
paragraph (b)(4)(viii)(c)(3)(ii) of this section. Third, partnership 
items attributable to each activity are aggregated within the relevant 
CFTE category as determined under paragraph (b)(4)(viii)(c)(2) of this

[[Page 35542]]

section in order to compute the net income in a CFTE category.
    (ii) Assignment of partnership items to activities. The items of 
gross income attributable to an activity must be determined in a 
consistent manner under any reasonable method taking into account all 
the facts and circumstances. Except as otherwise provided in paragraph 
(b)(4)(viii)(c)(3)(iii) of this section, expenses, losses, or other 
deductions must be allocated and apportioned to gross income 
attributable to an activity in accordance with the rules of Sec. Sec.  
1.861-8 and 1.861-8T. Under the rules Sec. Sec.  1.861-8 and 1.861-8T, 
if an expense, loss, or other deduction is allocated to gross income 
from more than one activity, such expense, loss, or deduction must be 
apportioned among each such activity using a reasonable method that 
reflects to a reasonably close extent the factual relationship between 
the deduction and the gross income from such activities. See Sec.  
1.861-8T(c). For the effect of disregarded payments in determining the 
amount of net income attributable to an activity, see paragraph 
(b)(4)(viii)(c)(3)(iv) of this section.
    (iii) Interest expense and research and experimental expenditures. 
The partnership's interest expense and research and experimental 
expenditures described in section 174 may be allocated and apportioned 
under any reasonable method, including but not limited to the methods 
prescribed in Sec. Sec.  1.861-9 through 1.861-13T (interest expense) 
and Sec.  1.861-17 (research and experimental expenditures).
    (iv) Disregarded payments. An item of gross income is assigned to 
the activity that generates the item of income that is recognized for 
U.S. Federal income tax purposes. Consequently, disregarded payments 
are not taken into account in determining the amount of net income 
attributable to an activity, although a special allocation of income 
used to make a disregarded payment may result in the subdivision of an 
activity into divisible parts. See paragraph (b)(4)(viii)(c)(2)(iii) of 
this section, Example 24 in paragraph (b)(5)(xxiv) of this section, and 
Examples 2 and 3 in paragraphs (b)(6)(ii) and (iii), respectively, of 
this section (relating to inter-branch payments).
    (4) CFTE category share of income--(i) In general. CFTE category 
share of income means the portion of the net income in a CFTE category, 
determined in accordance with paragraph (b)(4)(viii)(c)(3) of this 
section as modified by paragraphs (b)(4)(viii)(c)(4)(ii) through (iv) 
of this section, that is allocated to a partner. To the extent provided 
in paragraph (b)(4)(viii)(c)(4)(ii) of this section, a guaranteed 
payment is treated as an allocation to the recipient of the guaranteed 
payment for this purpose. If more than one partner receives positive 
income allocations (income in excess of expenses) from a CFTE category, 
which in the aggregate exceed the total net income in the CFTE 
category, then such partner's CFTE category share of income equals the 
partner's positive income allocation from the CFTE category, divided by 
the aggregate positive income allocations from the CFTE category, 
multiplied by the net income in the CFTE category. Paragraphs 
(b)(4)(viii)(c)(4)(ii) through (iv) of this section require adjustments 
to the net income in a CFTE category for purposes of determining the 
partners' CFTE category share of income if one or more foreign 
jurisdictions impose a tax that provides for certain exclusions or 
deductions from the foreign taxable base. Such adjustments apply only 
with respect to CFTEs attributable to the taxes that allow such 
exclusions or deductions. Thus, net income in a CFTE category may vary 
for purposes of applying paragraph (b)(4)(viii)(a)(1) of this section 
to different CFTEs within that CFTE category.
    (ii) Guaranteed payments. Except as otherwise provided in this 
paragraph (b)(4)(viii)(c)(4)(ii), solely for purposes of applying the 
safe harbor provisions of paragraph (b)(4)(viii)(a)(1) of this section, 
net income in the CFTE category from which a guaranteed payment (within 
the meaning of section 707(c)) is made is increased by the amount of 
the guaranteed payment that is deductible for U.S. Federal income tax 
purposes, and such amount is treated as an allocation to the recipient 
of such guaranteed payment for purposes of determining the partners' 
CFTE category shares of income. If a foreign tax allows (whether in the 
current or in a different taxable year) a deduction from its taxable 
base for a guaranteed payment, then solely for purposes of applying the 
safe harbor provisions of paragraph (b)(4)(viii)(a)(1) of this section 
to allocations of CFTEs that are attributable to that foreign tax, net 
income in the CFTE category is increased only to the extent that the 
amount of the guaranteed payment that is deductible for U.S. Federal 
income tax purposes exceeds the amount allowed as a deduction for 
purposes of the foreign tax, and such excess is treated as an 
allocation to the recipient of the guaranteed payment for purposes of 
determining the partners' CFTE category shares of income. See Example 1 
in paragraph (b)(6)(i) of this section.
    (iii) Preferential allocations. To the extent that a foreign tax 
allows (whether in the current or in a different taxable year) a 
deduction from its taxable base for an allocation (or distribution of 
an allocated amount) to a partner, then solely for purposes of applying 
the safe harbor provisions of paragraph (b)(4)(viii)(a)(1) of this 
section to allocations of CFTEs that are attributable to that foreign 
tax, the net income in the CFTE category from which the allocation is 
made is reduced by the amount of the allocation, and that amount is not 
treated as an allocation for purposes of determining the partners' CFTE 
category shares of income. See Example 1 in paragraph (b)(6)(i) of this 
section.
    (iv) Foreign law exclusions due to status of partner. If a foreign 
tax excludes an amount from its taxable base as a result of the status 
of a partner, then solely for purposes of applying the safe harbor 
provisions of paragraph (b)(4)(viii)(a)(1) of this section to 
allocations of CFTEs that are attributable to that foreign tax, the net 
income in the relevant CFTE category is reduced by the excluded amounts 
that are allocable to such partners. See Example 27 in paragraph 
(b)(5)(xxvii) of this section.
* * * * *
    (d) Allocation and apportionment of CFTEs to CFTE categories--(1) 
In general. CFTEs are allocated and apportioned to CFTE categories in 
accordance with the principles of Sec.  1.904-6. Under these 
principles, a CFTE is related to income in a CFTE category if the 
income is included in the base upon which the foreign tax is imposed. 
See Examples 2 and 3 in paragraphs (b)(6)(ii) and (iii) of this 
section, respectively, which illustrate the application of this 
paragraph in the case of serial disregarded payments subject to 
withholding tax. In accordance with Sec.  1.904-6(a)(1)(ii) as modified 
by this paragraph (b)(4)(viii)(d), if the foreign tax base includes 
income in more than one CFTE category, the CFTEs are apportioned among 
the CFTE categories based on the relative amounts of taxable income 
computed under foreign law in each CFTE category. For purposes of this 
paragraph (b)(4)(viii)(d), references in Sec.  1.904-6 to a separate 
category or separate categories mean ``CFTE category'' or ``CFTE 
categories'' and the rules in Sec.  1.904-6(a)(1)(ii) are modified as 
follows:
    (i) The related party interest expense rule in Sec.  1.904-
6(a)(1)(ii) shall not apply

[[Page 35543]]

in determining the amount of taxable income computed under foreign law 
in a CFTE category.
    (ii) If foreign law does not provide for the direct allocation or 
apportionment of expenses, losses or other deductions allowed under 
foreign law to a CFTE category of income, then such expenses, losses or 
other deductions must be allocated and apportioned to gross income as 
determined under foreign law in a manner that is consistent with the 
allocation and apportionment of such items for purposes of determining 
the net income in the CFTE categories for U.S. tax purposes pursuant to 
paragraph (b)(4)(viii)(c)(3) of this section.
* * * * *
     (6) Examples--(i) Example 1. (a) A contributes $750,000 and B 
contributes $250,000 to form AB, a country X eligible entity (as 
defined in Sec.  301.7701-3(a) of this chapter) treated as a 
partnership for U.S. Federal income tax purposes. AB operates 
business M in country X. Country X imposes a 20 percent tax on the 
net income from business M, which tax is a CFTE. In 2016, AB earns 
$300,000 of gross income, has deductible expenses of $100,000, and 
pays or accrues $40,000 of country X tax. Pursuant to the 
partnership agreement, the first $100,000 of gross income each year 
is specially allocated to A as a preferred return on excess capital 
contributed by A. All remaining partnership items, including CFTEs, 
are split evenly between A and B (50 percent each). The gross income 
allocation is not deductible in determining AB's taxable income 
under country X law. Assume that allocations of all items other than 
CFTEs are valid.
    (b) AB has a single CFTE category because all of AB's net income 
is allocated in the same ratio. See paragraph (b)(4)(viii)(c)(2) of 
this section. Under paragraph (b)(4)(viii)(c)(3) of this section, 
the net income in the single CFTE category is $200,000. The $40,000 
of taxes is allocated to the single CFTE category and, thus, is 
related to the $200,000 of net income in the single CFTE category. 
In 2016, AB's partnership agreement results in an allocation of 
$150,000 or 75 percent of the net income to A ($100,000 attributable 
to the gross income allocation plus $50,000 of the remaining 
$100,000 of net income) and $50,000 or 25 percent of the net income 
to B. AB's partnership agreement allocates the country X taxes in 
accordance with the partners' shares of partnership items remaining 
after the $100,000 gross income allocation. Therefore, AB allocates 
the country X taxes 50 percent to A ($20,000) and 50 percent to B 
($20,000). AB's allocations of country X taxes are not deemed to be 
in accordance with the partners' interests in the partnership under 
paragraph (b)(4)(viii) of this section because they are not in 
proportion to the allocations of the CFTE category shares of income 
to which the country X taxes relate. Accordingly, the country X 
taxes will be reallocated according to the partners' interests in 
the partnership. Assuming that the partners do not reasonably expect 
to claim a deduction for the CFTEs in determining their U.S. Federal 
income tax liabilities, a reallocation of the CFTEs under paragraph 
(b)(3) of this section would be 75 percent to A ($30,000) and 25 
percent to B ($10,000). If the reallocation of the CFTEs causes the 
partners' capital accounts not to reflect their contemplated 
economic arrangement, the partners may need to reallocate other 
partnership items to ensure that the tax consequences of the 
partnership's allocations are consistent with their contemplated 
economic arrangement over the term of the partnership.
    (c) The facts are the same as in paragraph (b)(6)(i)(a) of this 
section, except that country X allows a deduction for the $100,000 
allocation of gross income and, as a result, AB pays or accrues only 
$20,000 of foreign tax. Under paragraph (b)(4)(viii)(c)(4)(iii) of 
this section, the net income in the single CFTE category is 
$100,000, determined by reducing the net income in the CFTE category 
by the $100,000 of gross income that is allocated to A and for which 
country X allows a deduction in determining AB's taxable income. 
Pursuant to the partnership agreement, AB allocates the country X 
tax 50 percent to A ($10,000) and 50 percent to B ($10,000). This 
allocation is in proportion to the partners' CFTE category shares of 
the $100,000 net income. Accordingly, AB's allocations of country X 
taxes are deemed to be in accordance with the partners' interests in 
the partnership under paragraph (b)(4)(viii)(a) of this section.
    (d) The facts are the same as in paragraph (b)(6)(i)(c) of this 
section, except that, in addition to $20,000 of country X tax, AB is 
subject to $30,000 of country Y withholding tax with respect to the 
$300,000 of gross income that it earns in 2016. Country Y does not 
allow any deductions for purposes of determining the withholding 
tax. As described in paragraph (b)(6)(i)(b) of this section, there 
is a single CFTE category with respect to AB's net income. Both the 
$20,000 of country X tax and the $30,000 of country Y withholding 
tax relate to that income and are therefore allocated to the single 
CFTE category. Under paragraph (b)(4)(viii)(c)(4)(iii) of this 
section, however, net income in a CFTE category is reduced by the 
amount of an allocation for which a deduction is allowed in 
determining a foreign taxable base, but only for purposes of 
applying paragraph (b)(4)(viii)(a) of this section to allocations of 
CFTEs that are attributable to that foreign tax. Accordingly, 
because the $100,000 allocation of gross income is deductible for 
country X tax purposes but not for country Y tax purposes, the 
allocations of the CFTEs attributable to country X tax and country Y 
tax are analyzed separately. For purposes of applying paragraph 
(b)(4)(viii)(a)(1) of this section to allocations of the CFTEs 
attributable to the $20,000 tax imposed by country X, the analysis 
described in paragraph (b)(6)(i)(c) of this section applies. For 
purposes of applying paragraph (b)(4)(viii)(a)(1) of this section to 
allocations of the CFTEs attributable to the $30,000 tax imposed by 
country Y, which did not allow a deduction for the $100,000 gross 
income allocation, the net income in the single CFTE category is 
$200,000. Pursuant to the partnership agreement, AB allocates the 
country Y tax 50 percent to A ($15,000) and 50 percent to B 
($15,000). These allocations are not deemed to be in accordance with 
the partners' interests in the partnership under paragraph 
(b)(4)(viii) of this section because they are not in proportion to 
the partners' CFTE category shares of the $200,000 of net income in 
the category, which is allocated 75 percent to A and 25 percent to B 
under the partnership agreement. Accordingly, the country Y taxes 
will be reallocated according to the partners' interests in the 
partnership as described in paragraph (b)(6)(i)(b) of this section.
    (e) If, rather than being a preferential gross income 
allocation, the $100,000 was a guaranteed payment to A within the 
meaning of section 707(c), the amount of net income in the single 
CFTE category of AB for purposes of applying paragraph 
(b)(4)(viii)(a)(1) of this section to allocations of CFTEs would be 
the same as in the fact patterns described in paragraphs 
(b)(6)(i)(b), (c), and (d) of this section. See paragraph 
(b)(4)(viii)(c)(4)(ii) of this section.
     (ii) Example 2. (a) A, B, and C form ABC, an eligible entity 
(as defined in Sec.  301.7701-3(a) of this chapter) treated as a 
partnership for U.S. Federal income tax purposes. ABC owns three 
entities, DEX, DEY, and DEZ, which are organized in, and treated as 
corporations under the laws of, countries X, Y, and Z, respectively, 
and as disregarded entities for U.S. Federal income tax purposes. 
DEX operates business X in country X, DEY operates business Y in 
country Y, and DEZ operates business Z in country Z. Businesses X, 
Y, and Z relate to the licensing and sublicensing of intellectual 
property owned by DEZ. During 2016, DEX earns $100,000 of royalty 
income from unrelated payors on which it pays no withholding taxes. 
Country X imposes a 30 percent tax on DEX's net income. DEX makes 
royalty payments of $90,000 during 2016 to DEY that are deductible 
by DEX for country X purposes and subject to a 10 percent 
withholding tax imposed by country X. DEY earns no other income in 
2016. Country Y does not impose income or withholding taxes. DEY 
makes royalty payments of $80,000 during 2016 to DEZ. DEZ earns no 
other income in 2016. Country Z does not impose income or 
withholding taxes. The royalty payments from DEX to DEY and from DEY 
to DEZ are disregarded for U.S. Federal income tax purposes.
    (b) As a result of these payments, DEX has taxable income of 
$10,000 for country X purposes on which $3,000 of taxes are imposed, 
and DEY has $90,000 of income for country X withholding tax purposes 
on which $9,000 of withholding taxes are imposed. Pursuant to the 
partnership agreement, all partnership items from business X, 
excluding CFTEs paid or accrued by business X, are allocated 80 
percent to A and 10 percent each to B and C. All partnership items 
from business Y, excluding CFTEs paid or accrued by business Y, are 
allocated 80 percent to B and 10 percent each to A and C. All 
partnership items from business Z, excluding CFTEs paid or accrued 
by business Z, are allocated 80 percent to C and 10 percent each to 
A and B. Because only business X has items that are regarded for 
U.S. Federal income tax purposes (the

[[Page 35544]]

$100,000 of royalty income), only business X has partnership items. 
Accordingly A is allocated 80 percent of the income from business X 
($80,000) and B and C are each allocated 10 percent of the income 
from business X ($10,000 each). There are no partnership items of 
income from business Y or Z to allocate.
    (c) Because the partnership agreement provides for different 
allocations of partnership net income attributable to businesses X, 
Y, and Z, the net income attributable to each of businesses X, Y, 
and Z is income in separate CFTE categories. See paragraph 
(b)(4)(viii)(c)(2) of this section. Under paragraph 
(b)(4)(viii)(c)(3)(iv) of this section, an item of gross income that 
is recognized for U.S. Federal income tax purposes is assigned to 
the activity that generated the item, and disregarded inter-branch 
payments are not taken into account in determining net income 
attributable to an activity. Consequently, all $100,000 of ABC's 
income is attributable to the business X activity for U.S. Federal 
income tax purposes, and no net income is in the business Y or Z 
CFTE category. Under paragraph (b)(4)(viii)(d)(1) of this section, 
the $3,000 of country X taxes imposed on DEX is allocated to the 
business X CFTE category. The additional $9,000 of country X 
withholding tax imposed with respect to the inter-branch payment to 
DEY is also allocated to the business X CFTE category because for 
U.S. Federal income tax purposes the related $90,000 of income on 
which the country X withholding tax is imposed is in the business X 
CFTE category. Therefore, $12,000 of taxes ($3,000 of country X 
income taxes and $9,000 of the country X withholding taxes) is 
related to the $100,000 of net income in the business X CFTE. See 
paragraph (b)(4)(viii)(c)(1) of this section. The allocations of 
country X taxes will be in proportion to the CFTE category shares of 
income to which they relate and will be deemed to be in accordance 
with the partners' interests in the partnership if such taxes are 
allocated 80 percent to A and 10 percent each to B and C.
     (iii) Example 3. (a) Assume that the facts are the same as in 
paragraph (b)(5)(ii)(a) of this section, except that in order to 
reflect the $90,000 payment from DEX to DEY and the $80,000 payment 
from DEY to DEZ, the partnership agreement treats only $10,000 of 
the gross income as attributable to the business X activity, which 
the partnership agreement allocates 80 percent to A and 10 percent 
each to B and C. Of the remaining $90,000 of gross income, the 
partnership agreement treats $10,000 of the gross income as 
attributable to the business Y activity, which the partnership 
agreement allocates 80 percent to B and 10 percent each to A and C; 
and the partnership agreement treats $80,000 of the gross income as 
attributable to the business Z activity, which the partnership 
agreement allocates 80 percent to C and 10 percent each to A and B. 
In addition, the partnership agreement allocates the country X taxes 
among A, B, and C in accordance with which disregarded entity is 
considered to have paid the taxes for country X purposes. The 
partnership agreement allocates the $3,000 of country X income taxes 
80 percent to A and 10 percent to each of B and C, and allocates the 
$9,000 of country X withholding taxes 80 percent to B and 10 percent 
to each of A and C. Thus, ABC allocates the country X taxes $3,300 
to A (80 percent of $3,000 plus 10 percent of $9,000), $7,500 to B 
(10 percent of $3,000 plus 80 percent of $9,000), and $1,200 to C 
(10 percent of $3,000 plus 10 percent of $9,000).
    (b) In order to prevent separating the CFTEs from the related 
foreign income, the special allocations of the $10,000 and $80,000 
treated under the partnership agreement as attributable to the 
business Y and the business Z activities, respectively, which do not 
follow the allocation ratios that otherwise apply under the 
partnership agreement to items of income in the business X activity, 
are treated as divisible parts of the business X activity and, 
therefore, as separate activities. See paragraph 
(b)(4)(viii)(c)(2)(iii) of this section. Because the divisible part 
of the business X activity attributable to the portion of the 
disregarded payment received by DEY and not paid on to DEZ ($10,000) 
and the net income from the business Y activity ($0) are both shared 
80 percent to B and 10 percent each to A and C, that divisible part 
of the business X activity and the business Y activity are treated 
as a single CFTE category. Because the divisible part of the 
business X activity attributable to the disregarded payment paid to 
DEZ ($80,000) and the net income from the business Z activity ($0) 
are both shared 80 percent to C and 10 percent each to A and B, that 
divisible part of the business X activity and the business Z 
activity are also treated as a single CFTE category. See paragraph 
(b)(4)(viii)(c)(2)(i) of this section. Accordingly, $10,000 of net 
income attributable to business X is in the business X CFTE 
category, $10,000 of net income of business X attributable to the 
net disregarded payments of DEY is in the business Y CFTE category, 
and $80,000 of net income of business X attributable to the 
disregarded payment to DEZ is in the business Z CFTE category.
    (c) Under paragraph (b)(4)(viii)(d)(1) of this section, the 
$3,000 of country X tax imposed on DEX's income is allocated to the 
business X CFTE category. Because the $90,000 on which the country X 
withholding tax is imposed is split between the business Y CFTE 
category and the business Z CFTE category, those withholding taxes 
are allocated on a pro rata basis, $1,000 [$9,000 x ($10,000/
$90,000)] to the business Y CFTE category and $8,000 [$9,000 x 
($80,000/$90,000)] to the business Z CFTE category. See paragraph 
(b)(4)(viii)(d)(1) of this section. To satisfy the safe harbor of 
paragraph (b)(4)(viii) of this section, the $3,000 of country X 
taxes allocated to the business X CFTE category must be allocated in 
proportion to the CFTE category shares of income to which they 
relate, and therefore would be deemed to be in accordance with the 
partners' interests in the partnership if such taxes were allocated 
80 percent to A and 10 percent each to B and C. The allocation of 
the $1,000 of country X withholding taxes allocated to the business 
Y CFTE category would be in proportion to the CFTE category shares 
of income to which they relate, and therefore would be deemed to be 
in accordance with the partners' interests in the partnership if 
such taxes were allocated 80 percent to B and 10 percent each to A 
and C. The allocation of the $8,000 of country X withholding taxes 
allocated to the business Z CFTE category would be in proportion to 
the CFTE category shares of income to which they relate, and 
therefore would be deemed to be in accordance with the partners' 
interests in the partnership if such taxes were allocated 80 percent 
to C and 10 percent each to A and B. Thus, to satisfy the safe 
harbor, ABC must allocate the country X taxes $3,300 to A (80 
percent of $3,000 plus 10 percent of $1,000 plus 10 percent of 
$8,000), $1,900 to B (10 percent of $3,000 plus 80 percent of $1,000 
plus 10 percent of $8,000), and $6,800 to C (10 percent of $3,000 
plus 10 percent of $1,000 plus 80 percent of $8,000).
    (d) ABC's allocations of country X taxes are not deemed to be in 
accordance with the partners' interests in the partnership under 
paragraph (b)(4)(viii) of this section because they are not in 
proportion to the partners' CFTE category shares of income to which 
the country X taxes relate. Accordingly, the country X taxes will be 
reallocated according to the partners' interests in the partnership.
* * * * *

0
Par. 3. Section 1.704-1T is amended by:
0
1. Removing reserved paragraphs (a) through (b)(1)(ii)(a), paragraph 
(b)(1)(ii)(b), and reserved paragraphs (b)(1)(iii) through 
(b)(2)(iv)(f)(5).
0
2. Adding paragraphs (a), (b)(1), and (b)(2) introductory text and 
reserved paragraphs (b)(2)(i) through (b)(2)(iv)(e) and 
(b)(2)(iv)(f)(1) through (5).
0
3. Removing reserved paragraphs (b)(2)(iv)(g) through (b)(4)(viii)(a) 
introductory text, paragraph (b)(4)(viii)(a)(1), reserved paragraphs 
(b)(4)(viii)(a)(2) through (b)(4)(viii)(b), paragraph (b)(4)(viii)(c), 
paragraph (b)(4)(viii)(d) heading, paragraph (b)(4)(viii)(d)(1), 
reserved paragraphs (b)(4)(viii)(d)(1)(i) through (b)(5) Example 24, 
paragraphs (b)(5) Examples 24 through 37, and reserved paragraphs (c) 
through (e).
0
4. Adding paragraph (b)(2)(iv)(g), reserved paragraphs (b)(2)(iv)(h) 
through (s), paragraph (b)(3), reserved paragraphs (b)(4) through (6), 
paragraph (c), and reserved paragraphs (d) through (e).
0
5. Removing paragraph (g).
    The additions read as follows:


Sec.  1.704-1T  Partner's distributive share (temporary).

    (a) For further guidance, see Sec.  1.704-1(a).
    (b)(1) For further guidance, see Sec.  1.704-1(b)(1).
    (2) For further guidance, see Sec.  1.704-1(b)(2)(i) through 
(b)(2)(iv)(f)(5).
    (i) through (iii) [Reserved]

[[Page 35545]]

    (iv)(a) through (e) [Reserved]
    (f)(1) through (5) [Reserved]
* * * * *
    (g) For further guidance, see Sec.  1.704-1(b)(2)(iv)(g) through 
(s).
    (h) through (s) [Reserved]
    (3) For further guidance, see Sec.  1.704-1(b)(3) through (6).
    (4) through (6) [Reserved]
    (c) For further guidance, see Sec.  1.704-1(c) through (e).
    (d) through (e) [Reserved]
* * * * *

    Approved: May 30, 2019.
Kirsten Wielobob,
Deputy Commissioner for Services and Enforcement.

David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2019-15362 Filed 7-23-19; 8:45 am]
BILLING CODE 4830-01-P