Final Foreign Tax Credit Regulations Released with Immediate Effect, Putting Creditability of Foreign Taxes at Risk
On December 28, 2021, the U.S. Department of the Treasury (Treasury) and the Internal Review Service (IRS) filed with the Federal Register final regulations addressing several issues central to foreign tax credits (TD 9959) (the Final Regulations).1 The Final Regulations generally finalized the proposed foreign tax credit regulations released on November 12, 2020 (REG-101657-20) (the Proposed Regulations).2 Among other items, the Proposed Regulations introduced new requirements for a foreign tax to be creditable under sections 901 and 903, including the addition of a jurisdictional nexus requirement and changes to the net gain requirement. The Final Regulations adopt the new requirements with modest changes despite public pushback against the controversial new provisions.
The new rules will limit foreign tax credits for foreign taxes that were clearly creditable under prior law and will raise practical and interpretive issues for taxpayers in routine fact patterns. The rules limit foreign tax credits to foreign income taxes that conform closely to U.S. tax law, including with respect to the application of the arm's length principle, the allowance of deductions, and the sourcing of income earned by non-residents. In particular, withholding taxes on services and royalties imposed on the basis of the residence of the payor or on a similar basis will not be creditable except when imposed directly on a U.S. taxpayer that benefits from a U.S. tax treaty that permits a credit. These taxes are common outside of the U.S. tax treaty network. Taxpayers will have to evaluate the creditability of foreign taxes to which they are subject and consider whether it is possible to mitigate or avoid the negative outcomes under the rules.
In addition to the rules on creditability, the Final Regulations finalized new rules addressing the following issues:
- Determination of foreign income taxes subject to the credit and deduction disallowance rules under section 245A(d)
- Determination of oil and gas extraction income from domestic and foreign sources
- Impact of the repeal of section 902 on certain regulations issued under section 367(b)
- Sourcing of inclusions under sections 951, 951A, and 1293
- Allocation and apportionment of certain items, including interest deductions of certain regulated utilities, section 818(f)(1) items for life insurance companies, and foreign taxes imposed on disregarded payments
- Allocation of the liability for foreign income taxes in connection with certain mid-year transfers or reorganizations
- Foreign branch category rules in §1.904-4(f)
- Timing of when foreign income tax credits may be claimed
The majority of provisions in the Proposed Regulations were finalized. Treasury and the IRS did not finalize the following provisions of the Proposed Regulations, which they continue to study:
- Proposed Regulation § 1.861-9(k) related to the election to capitalize advertising and research and experimentation expenses in determining tax book value of assets
- Proposed Regulation § 1.861-10(g) providing for direct allocation of interest expense in the case of certain foreign banking branches
- Proposed Regulation §§ 1.904-4(e)(1)(ii) and 1.904-5(b)(2) related to the definition of financial services income
Key aspects of the Final Regulations related to the creditability of foreign taxes (Treas. Reg. § 1.901-2) are discussed below.
Overview of Changes to Creditability of Foreign Taxes
The Proposed Regulations introduced a new jurisdictional nexus requirement under which a foreign levy would be treated as a creditable foreign income tax only if foreign tax law requires a sufficient nexus between the foreign country and the taxpayer's activities or investments that give rise to the income being taxed. The Proposed Regulations tested whether nexus was sufficient on the basis of U.S. tax law principles for taxing non-residents and allocating income to residents. The Proposed Regulations also modified elements of the long-standing net gain test, generally providing that a foreign income tax satisfies those elements only if it conforms closely to U.S. tax law. These controversial proposals represented a departure from established law and sparked comments questioning their consistency with legislative intent and the historical understanding of the meaning of a foreign income tax under section 901. The Preamble to the Final Regulations defends the proposed rules, asserting that they align with U.S. concepts underlying the taxation of non-residents as well as the policy of ensuring that foreign tax credits do not erode U.S. tax on U.S. income. Consequently, the Final Regulations essentially adopt the jurisdictional nexus requirement and changes to the net gain test with a few substantive differences.
Attribution Requirements/Jurisdictional Nexus
The Final Regulations effectively incorporate the jurisdictional nexus requirement into the net gain test, providing in general that a foreign tax meets the net gain test only if the jurisdictional basis for its imposition conforms to the nexus rules that govern U.S. taxation in analogous circumstances. The Final Regulations provide that under the net gain test, the amount of gross receipts and costs that are included in the base of the foreign tax on a non-resident must meet one of the "attribution requirements," which generally match the jurisdictional nexus requirements contained in the Proposed Regulations: (1) income attribution based on activities; (2) income attribution based on source; and (3) income attribution based on situs of property. In the case of a foreign tax imposed by a foreign country on its residents, the Final Regulations provide that, to meet the net gain requirement, any allocation of income or deduction between a resident taxpayer and an affiliate must follow arm's length principles. The Final Regulations provide that a tax can qualify as a creditable tax in lieu of an income tax only if the tax is in substitution for an income tax that would meet the attribution requirements, with specific rules applicable to withholding taxes.
In order to satisfy the requirement for income attribution based on source, the applicable foreign sourcing rules must be "reasonably similar" to the sourcing rules that apply for U.S. income tax purposes. The Final Regulations clarify that the foreign law need not conform in all respects. For instance, as explained in the Preamble to the Final Regulations, in determining the place of use of an intangible in a particular arrangement under a rule similar to the U.S. sourcing rule applicable to royalties, foreign law need not reach the same conclusion as the IRS or a U.S. court. The Final Regulations provide that the source for service income must be the location of the performance of the service and cannot be determined based on the location of the service recipient and clarify that royalty income must be sourced based on the place of use of, or the right to use, the intangible property.
However, in an important clarification, the Final Regulations in general provide that the character of gross income arising from gross receipts is determined under the foreign tax law. Accordingly, the determination of whether gross income is royalty income or a fee for services, for example, is made in accordance with the characterization rules of foreign law. An exception is provided in the case of income arising from sales of copyrighted articles. For sales of copyrighted articles, a foreign tax on gains from such sales (determined based on U.S. tax characterization rules) satisfies the source-based attribution requirement if it is based on rules consistent with U.S. law treatment of such gains, without regard to foreign law characterization.
Taxpayers benefiting from foreign tax credits will need to evaluate the extent to which the foreign taxes to which they are subject remain creditable under the new rules. That is particularly the case for taxpayers subject to withholding taxes on service fees or royalties and taxes on share gains. To the extent taxes do not meet the new standards, taxpayers should consider whether it is possible to mitigate negative impacts, for example by restructuring transactional or payment flows.
Net Gain Test
Under the long-standing net gain test, a foreign tax is evaluated based on the events that trigger liability for tax (realization), the revenue subject to tax (gross receipts), and whether the tax permits the recovery of significant costs or expenses attributable to those gross receipts (net income requirement). The Proposed Regulations generally required that whether a foreign tax satisfied each of the realization, gross receipts, and cost recovery requirements be based on the terms of the foreign tax law governing the computation of the tax base, not empirical analysis, and that the foreign tax conform closely to analogous U.S. law with respect to each requirement. The Final Regulations largely adopt these rules with modest changes.
Generally, a foreign tax satisfies the gross receipts requirement if, judged on the basis of its predominant character, it is imposed on the basis of gross receipts. Under prior law, a foreign tax could also satisfy this requirement if it was imposed on the basis of gross receipts computed under a method that was likely to produce an amount that is not greater than the fair market value of actual arm's length gross receipts (the alternative gross receipts test). As with the Proposed Regulations, the Final Regulations eliminate the alternative gross receipts test. In response to comments, the Final Regulations provide that deemed gross receipts resulting from deemed realization events or insignificant non-realization events that meet the realization requirement could also meet the gross receipts requirement if the deemed gross receipts are reasonably calculated to produce an amount that is not greater than fair market value.
Consistent with the Proposed Regulations, the Final Regulations provide that a foreign tax must "permit recovery of the significant costs and expenses…under reasonable principles" in order to meet the cost recovery requirement (formerly the net income requirement). The Final Regulations deem certain costs to be significant costs that must be recoverable in all cases: capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation. Foreign law disallowances are permissible "if such disallowance is consistent with the principles underlying the disallowances required under the Internal Revenue Code, including disallowances intended to limit base erosion and profit shifting." As an example of a foreign tax disallowance that is stricter than U.S. tax law but would still be considered to satisfy the cost recovery, the Final Regulations put forth a foreign tax that disallows interest expense in excess of 10 percent of taxable income. Taxpayers may find it difficult to extend these principles beyond this example to real-world fact patterns.
The Final Regulations eliminate prior-law rules treating a foreign levy whose base is gross receipts as meeting the cost recovery requirement if the foreign levy is almost certain to reach net gain because (1) costs and expenses will almost never be so high as to offset gross receipts or gross income and (2) the rate of the tax is such that after the tax is paid persons subject to the tax are almost certain to have net gain. In response to comments, the Final Regulations provide that a gross basis tax may meet the cost recovery requirement if in fact there are no significant costs and expenses attributable to the gross receipts included in the taxable base.
The Final Regulations also follow the Proposed Regulations approach of all but eliminating the alternative allowance rules. Under prior law, a foreign tax that did not permit recovery of one or more significant costs or expenses but provided allowances that effectively compensated for non-recovery of such significant costs or expenses was considered to meet the cost recovery requirement. The Final Regulations limit this exception to foreign tax laws that by their terms (as opposed to empirically) only permit recovery of amounts that can never be less than the actual amounts of significant costs and expense. The Final Regulations allow an exception to this rule for small businesses.
The Final Regulations confirm that a foreign tax that is treated as an income tax under the relief from double taxation article of a U.S. tax treaty is considered a creditable tax for purposes of section 901 "if paid by a citizen or resident of the United States" that elects benefits under the Treaty. See Treas. Reg. § 1.901-1(a)(2)(iii). The Preamble to the Proposed Regulations had stated as much, but the inclusion of this statement in the text of the Final Regulations is a welcome development. The concession to tax treaties may be less helpful than hoped, however, because it does not apply to foreign taxes paid by non-U.S. residents. For example, the foreign subsidiaries (controlled foreign corporations (CFCs)) of a U.S. company are not U.S. residents who can claim the benefits of U.S. tax treaties, even though the U.S. company includes global intangible low-taxed income (GILTI) and subpart F income of such CFCs and is generally entitled to a section 960 deemed paid credit with respect to such inclusions.
Consistent with the Proposed Regulations, the Final Regulations generally provide that tax credits are considered to reduce the amount of foreign tax paid regardless of whether the amount of the tax credit in excess of tax liability is refundable in cash. This rule also applies to tax credits transferred from another taxpayer. In response to comments criticizing the disparate treatment of refundable credits and government grants, the Final Regulations provide that a tax credit will not be treated as reducing a foreign tax liability if the taxpayer has the option to receive in cash the full amount of the tax credit. A tax credit that is fully payable in cash therefore would be treated as a means of paying a foreign tax liability, rather than a reduction in the foreign tax liability.
Under long-standing regulations, an amount remitted is not a compulsory payment, and so is not an amount of foreign income tax paid, to the extent the taxpayer failed to minimize the amount of foreign tax due over time. Consistent with the Proposed Regulations, the Final Regulations provide that the reference to "foreign tax" means "foreign income tax," and that therefore taxpayers are required take reasonable steps to minimize their liability for foreign income taxes, including by exhausting remedies that an economically rational taxpayer would pursue whether the amount at issue was eligible for the foreign tax credit or not. In one interesting addition in the Final Regulations, the non-compulsory payment rule now provides that "the reasonably expected, arm's length costs" of reducing foreign income tax liability "may include an additional liability for a different foreign tax (but not U.S. taxes) that is not a foreign income tax" so long as the additional liability is otherwise a compulsory payment. This provision is illustrated with an example involving a taxpayer that agrees to pay additional foreign income tax (by forgoing deductions) in order to reduce its liability under a non-creditable base erosion tax by a greater amount.
The Final Regulations also provide that the taxpayer's decision to join, or not join, a foreign consolidated group, or to elect to surrender losses, or not surrender losses, to a group member does not violate the non-compulsory payment rule. However, the Final Regulations generally apply the non-compulsory payment on a separate entity basis, rather than a group basis, due to Treasury and the IRS's conclusion that it is too difficult to define a group in a way that properly accounts for differences in U.S. and foreign tax law and prevents abuse. The Final Regulations provide a limited exception for related parties to waive certain deductions or otherwise increase one party's foreign income tax liability and reduce another party's foreign income tax liability, through the application of foreign law hybrid mismatch rules, without violating the non-compulsory payment rule.
Provisional Credit for Contested Taxes
Under the Proposed Regulations, a taxpayer could not claim a foreign tax credit for contested foreign income taxes until the contest was resolved, even if the contested taxes were remitted to the foreign country. An accrual basis taxpayer, however, could elect an exception to this rule to claim a provisional credit on the remitted foreign taxes, provided the taxpayer waived the statute of limitations as a defense and fulfilled certain annual reporting requirements. If the taxpayer failed to comply with those annual reporting requirements, it would be treated as receiving a refund of the amount of the contested foreign income tax liability.
The Final Regulations retain the election and procedures for claiming a provisional credit for contested taxes but omit the penalty of treating failure to comply with annual reporting as a deemed refund. Treasury and the IRS were persuaded that the government's interest in the contested taxes is protected by the election to waive the statute of limitations. In addition, the Final Regulations clarify that the provisional foreign tax credit can only be made for contested foreign income taxes that relate to a taxable year in which the taxpayer has made the election under section 901 to claim a credit (instead of a deduction) for foreign income taxes that accrue in such year.
In general, the provisions of the Final Regulations that relate to the creditability of foreign taxes (i.e., the amendments to Treasury Regulation § 1.901-2) apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021 (the date on which the final regulations were filed with the Federal Register). See Treas. Reg. § 1.901-2(h). However, a special transition rule applies to defer for one year the applicability date of the Final Regulations under section 903 with respect to certain taxes paid to Puerto Rico. Id. For applicability dates of other provisions of the Final Regulations, see Treas. Reg. §§ 1.164-2(i), 1.245A(d)-1(f), 1.336-5, 1.338-9(d)(4), 1.367(b)-7(h), 1.367(b)-10(e), 1.861-3(e), 1.861-9(k), 1.861-10(h), 1.861-14(k), 1.861-20(i), 1.901-1(j), 1.903-1(e), 1.904-6(g), 1.905-1(h), 1.905-3(d), 1.951A-7, and 1.960-7.
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1 The Final Regulations were published in the Federal Register on January 4, 2022. 87 F.R. 276.
2 Our previous alerts on the Proposed Regulations are available here: "Treasury Issues Foreign Tax Credit Regulations Addressing Expense Allocation and Technical Issues, and Proposes Fundamental Changes to Longstanding Creditability Requirements for Foreign Income Taxes" and "Proposed FTC Regulations Would Upend Creditability Standards."
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