Proposed Foreign Tax Credit Regulations Provide Limited Relief on Royalty Withholding Taxes and Cost Recovery Requirements
On November 18, 2022, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released proposed regulations responding to taxpayer concerns with final foreign tax credit regulations published in January 2022 (2022 FTC Regulations).1 The proposed rules offer limited relief on two burdensome aspects of the 2022 FTC Regulations: the attribution rules for royalty withholding taxes and the cost recovery requirements. The proposed rules do not affect the creditability of withholding tax on services. With immediate effect, taxpayers may rely on the relief provided by the proposed regulations.
This Tax Alert summarizes the proposed rules, which may have the effect of restoring the creditability of certain foreign taxes disqualified under the 2022 FTC Regulations. Taxpayers should revisit their prior determinations and consider whether restructuring will further improve their foreign tax credit profile. To qualify for relief under the newly proposed exception for royalties, taxpayers may need to amend existing license agreements, with a transition rule requiring documentation for current royalties to be completed by May 17, 2023. Comments on the proposed regulations must be received by January 23, 2023.
Royalty Withholding Taxes
Under the 2022 FTC Regulations, foreign withholding tax imposed on royalties may not be creditable unless, among other things, foreign law sources the royalties based on the place of use, or the right to use, the intangible property (IP).2 Royalty withholding taxes imposed based on the residence of the payor (or a similar rule) are disqualified on an "all-or-nothing" basis, even if the licensed IP is used solely within the foreign country imposing the tax.3 In the new proposed rules, Treasury and the IRS acknowledge that this outcome is inconsistent with sound tax policy, as "the foreign country imposing tax on the royalty income should, from a U.S. perspective, have the primary taxing right over the royalty income because the intangible property giving rise to the royalty is in fact being used solely in that foreign country."4
To address this concern, the proposed regulations introduce an exception for withholding taxes on royalties paid pursuant to "single-country licenses."5 Under the proposed exception, a tested foreign tax will satisfy the requirement to source based on "place of use" if the income subject to foreign tax is characterized as gross royalty income under foreign law and royalties are paid pursuant to a "single-country license."6 The single-country license agreement (1) must characterize payments as royalties and (2) limit the territory of the license to the foreign country imposing the tested foreign tax.7 The proposed rules do not address how to determine "the territory in which the relevant intangible property is used."8
Licensing arrangements frequently provide licensees with the right to exploit IP in multiple countries. In addition, it is common for a single agreement to cover royalties and technical services. The proposed rules allow such arrangements to satisfy the single-country license exception if the agreement "separately states" the amount of the payment attributable to royalties for use of IP in the country imposing the tested foreign tax.9 To prevent manipulation, the separately stated amount must adhere to "the principles of sections 482 and 861."10 Caution is warranted, as the rules impose a cliff effect. If the taxpayer "knew or had reason to know" that royalty allocations were inconsistent with transfer pricing principles, the entire withholding tax is disqualified.11
Qualifying license agreements must be executed by the taxpayer on or before the date a royalty is paid.12 Under a transition rule, agreements executed by May 17, 2023, may state that royalties paid on an earlier date are considered paid pursuant to the terms of the subsequent agreement.13 The documentation requirement may pose challenges to taxpayers with substantial third-party license agreements. Even if the place of actual use does not change, counterparties with existing global or regional licenses may request concessions for agreeing to restrict the place of use to a specific country or to providing a separately stated amount for royalties for use of IP in particular countries.
Cost Recovery Requirements
Under the 2022 FTC Regulations, a foreign net income tax is not creditable unless it permits recovery of "significant costs and expenses," including a specific list of expenses that "are always treated as significant[.]"14 Foreign tax law may disallow recovery of certain expenses and satisfy the requirement, if the disallowance is consistent with "any principle" in the Internal Revenue Code (the Code), such as the principle of limiting base erosion and profit shifting.15
In the preamble to the new proposed rules, Treasury and the IRS acknowledge that taxpayers may not be able to reliably discern the principles underlying disallowances in U.S. and foreign tax law. The proposed regulations would relax the cost recovery requirement, allowing foreign tax law to satisfy cost recovery if it permits "substantially all" of each item of significant cost and expense to be recovered.16 If an expense disallowance satisfies the "substantially all" threshold, it is no longer necessary to determine whether that disallowance is consistent with a corresponding principle in the Code.
The proposed rules provide an express safe harbor for determining that foreign law satisfies the "substantially all" standard.17 Under the safe harbor, disallowance of 25 percent or less of an item of significant cost or expense will not prevent a foreign tax from satisfying the "substantially all" test. The safe harbor also permits foreign tax law to "cap" certain deductions as a percentage of gross receipts (15 percent limit) or as a percentage of taxable income (30 percent limit). For example, foreign tax law that caps recovery of interest expense at 30 percent of taxable income (i.e., consistent with Code section 163(j)) does not prevent the tax from being considered to permit recovery of "substantially all" interest expense.18
If a foreign tax disallowance does not fall within the safe harbor, the proposed regulations clarify the "principles-based" exception to cost recovery. If the foreign disallowance addresses a non-tax public policy concern, that concern must be similar to non-tax public policy concerns addressed in the Code. The proposed rules add an example concluding that foreign law may deny deductions for all stock-based compensation and still satisfy the cost recovery requirement, because U.S. tax law limits deductions for certain executive compensation for "non-tax public policy reasons, including to influence the amount or use of a certain type of compensation in the labor market."19
Reattribution Asset Rule
In a separate provision of the proposed regulations, Treasury and the IRS have concluded that the rule in Treas. Reg. § 1.861-20 that reattributes assets from one taxable unit to another taxable unit is not needed in the case of disregarded property sales. Under the proposed rules, the definition of reattribution assets would be modified to exclude the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable unit. The proposed rules do not otherwise propose changes to the rules for disregarded payments, such as the general rules for reattribution assets or the rules that characterize foreign taxes on remittances based on assets.
In general, the proposed regulations are proposed to apply to tax years ending on or after November 18, 2022 (i.e., starting immediately in 2022 for calendar-year taxpayers).20 Once the proposed regulations are finalized, taxpayers may choose to apply "some or all of the final regulations to earlier taxable years, subject to certain conditions" described in detail in the notice of proposed rulemaking.
Until the effective date of final regulations, taxpayers may rely on the proposed regulations. If a taxpayer chooses to rely on a "portion" of the proposed regulations (changes to the attribution requirement for royalty payments, changes to the cost recovery requirements, or changes to the reattribution asset rule), taxpayers must consistently follow all proposed rules for that "portion" of the regulations for all years until final regulations are effective.21
While the 2022 FTC Regulations offer welcome relief in specific areas, the relief is limited. Notably, the "single-country license" exception is inapplicable in cases where the foreign country imposing the withholding tax has a direct corporate income tax regime that does not comport with the arm's length standard (e.g., Brazil). Further, the application of the "separately stated" rule to all but the simplest arrangements may not be clear, potentially resulting in withholding taxes imposed in a particular jurisdiction being creditable to some taxpayers but not others. Taxpayers are encouraged to submit comments to address these gaps and any others identified with the 2022 FTC Regulations, as this is perhaps only the first instance of Treasury's reconsideration of the principles set forth in the final foreign tax credit regulations.
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1T.D. 9959, 87 Fed. Reg. 276 (Jan. 4, 2022). For our prior coverage of the 2022 FTC Regulations, click here.
2Treas. Reg. § 1.903-1(c)(2)(iii); § 1.901-2(b)(5)(i)(B)(2).
3Treas. Reg. § 1.903-1(b)(1), -1(d)(3), (4). Such tax may be creditable when imposed directly on a U.S. taxpayer that benefits from a U.S. tax treaty that permits a credit. Treas. Reg. § 1.901-2(a)(1)(iii).
4NPRM, 87 Fed. Reg. 71,271, 71,275 (Nov. 22, 2022).
5Prop. Reg. § 1.903-1(c)(2)(iii)(B), -1(c)(2)(iv).
6Income from the sale of a copyrighted article is not characterized as royalty income, regardless of the characterization under foreign law. Prop. Reg. § 1.903-1(c)(2)(iii)(B).
7Prop. Reg. § 1.903-1(c)(2)(iv)(A).
8Prop. Reg. § 1.903-1(c)(2)(iv)(C).
9Prop. Reg. § 1.903-1(c)(2)(iv)(B).
10Prop. Reg. § 1.903-1(c)(2)(iv)(C).
11Prop. Reg. § 1.903-1(d)(11).
12Prop. Reg. § 1.903-1(c)(2)(iv)(D).
13Prop. Reg. § 1.903-1(c)(2)(iv)(D).
14Treas. Reg. § 1.901-2(b)(4)(i)(A), (C). The per se list of expenses includes capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation.
15In July 2022, Treasury and the IRS issued technical corrections which broadened this exception from "the principles" underlying the disallowances required under the Internal Revenue Code to "any principle." 87 Fed. Reg. 45,021 (July 27, 2022).
16Prop. Reg. § 1.901-2(b)(4)(i).
17Prop. Reg. § 1.901-2(b)(4)(i)(C)(2).
18Prop. Reg. § 1.901-2(b)(4)(i)(H) (Ex. 8). As noted in the preamble to the proposed regulations, a combined cap on multiple categories of significant expense may not satisfy the safe harbor. 87 Fed. Reg. at 71,274.
19Prop. Reg. § 1.901-2(b)(4)(i)(J) (Ex. 10).
20The changes to Treas. Reg. § 1.861-20 are proposed to apply to tax years ending on or after the date final regulations adopting the rules are filed with the Federal Register. However, once finalized, taxpayers will be permitted to apply the rules to taxable years beginning after December 31, 2019.
21NRPM, 87 Fed. Reg. at 71,277.
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