Treasury Issues Foreign Tax Credit Regulations Addressing Expense Allocation and Technical Issues, and Proposes Fundamental Changes to Longstanding Creditability Requirements for Foreign Income Taxes
On September 29, 2020, the Treasury Department and IRS issued final and proposed regulations addressing a host of issues relating to the foreign tax credit, including proposed regulations that contain new requirements for a foreign tax to be creditable under sections 901 and 903. Issued as part of the third set of foreign tax credit guidance addressing changes arising from the Tax Cuts and Jobs Act (TCJA), the new rules (REG-101657-20) (the "Proposed Regulations") include the addition of a jurisdictional nexus requirement and changes to the net gain requirement of prior law. The regulatory package also includes final regulations (TD 9922) (the "Final Regulations") that largely finalize certain regulations proposed last December (REG-105495-19) (the "2019 Proposed Regulations").
The Final Regulations provide guidance on several foreign tax credit issues arising from the TCJA, including: foreign tax redeterminations; allocation and apportionment of expenses, including research and experimentation (R&E) expense, stewardship expense, damages payments in litigation, and foreign taxes; the interaction of the branch loss and dual consolidated loss recapture rules with the overall foreign loss (OFL) and overall domestic loss (ODL) rules of section 904(f) and (g). In addition, the Final Regulations finalize rules relating to hybrid deduction accounts under section 245A(e) and the application of the conduit financing rules of Treas. Reg. § 1.881-3 to hybrid instruments that were proposed in April 2020.1 We discuss aspects of the Final Regulations in more detail below.
In addition to the proposed overhaul of the definition of a creditable foreign income tax, the Proposed Regulations address topics including: the allocation and apportionment of foreign taxes on disregarded payments; the allocation of foreign taxes on exempt dividends for purposes of section 245A(d); the determination of oil and gas extraction income from domestic and foreign sources; the source of inclusions of subpart F and global intangible low-taxed income (GILTI); rules regarding the timing of when a foreign tax credit may be claimed; the impact of the repeal of section 902 on the section 367(b) regulations; revisions to the interest expense allocation and apportionment rules (including rules for foreign bank branches and regulated utilities, and an election to capitalize R&E expenditures and advertising for purposes of interest expense apportionment); and allocation and apportionment of section 818(f) expenses of life insurance companies in a consolidated group. Finally, the Proposed Regulations include a revised definition of electronically supplied services for purposes of the deduction for foreign-derived intangible income (FDII). Aspects of the Proposed Regulations are discussed below.
I. ALLOCATION AND APPORTIONMENT OF R&E EXPENSES – FINAL AND PROPOSED REGULATIONS
The Final Regulations finalize rules governing the allocation and apportionment of R&E expenditures for purposes of the foreign tax credit and FDII rules. The final rules are generally consistent with the guidance set forth in the 2019 Proposed Regulations. In addition, the IRS and Treasury clarified the operation of these rules with respect to foreign branches, both in these Final Regulations and in the new set of Proposed Regulations.
A. Definition of Gross Intangible Income
The class of gross income of the taxpayer to which R&E expenditures are deemed to relate is defined as gross intangible income (GII), or "all income attributable, in whole or in part, to intangible property, including sales or leases of products or services derived, in whole or in part, from intangible property, income from the sale of intangible property, income from platform contribution transactions, royalty income, and amounts taken into account under section 367(d) by reason of a transfer of intangible property."2 The Final Regulations make no modifications to the proposed definition of GII and clarify the theory underpinning the allocation and apportionment rules by establishing that GII is the class of income of the taxpayer to which R&E expenditures are considered to "reasonably relate." The Final Regulations eschew a tracing approach that would require a strict factual connection between R&E expense to GII generated in a particular taxable year, and make clear that R&E expenditures are not reasonably expected to generate current year income, given their speculative nature.3 Accordingly, GII is considered to be the best available proxy for the income current year R&E expenditures are expected to generate in the future.
With respect to amounts giving rise to GII, the Final Regulations retain the exclusion of GILTI on the rationale that those inclusions represent income earned by the controlled financial corporation (CFC) net of amounts paid for the use of intangible property developed by U.S. affiliates. Conversely, despite many comments requesting the contrary, the Final Regulations continue to include FDII in GII, as FDII represents income earned by the taxpayer that incurs the R&E expense, and that income could include a return on that expense. Further, Treasury determined that FDII's inclusion in GII is appropriate because the Code requires gross income giving rise to FDII to be reduced by the deductions properly allocable to it,4 and there is no evidence of congressional intent to exclude deductions taken for R&E expenditures.
B. Scope of Exclusive Apportionment Method
With regard to R&E expense apportionment, the Final Regulations decline to permit use of the exclusive apportionment method, under which 50 percent of R&E expense would be apportioned based on the predominant location of R&E activities, for purposes of calculating a taxpayer's FDII deduction.5 The IRS and Treasury expressly reject the proposition that applying the exclusive apportionment method for purposes of FDII is appropriate because it would incentivize domestic R&E activity by increasing the FDII deduction. In so doing, the preamble to the Final Regulations observes that applying the exclusive apportionment method in this context would seriously undermine the representations Treasury has made before the Organisation for Economic Co-operation and Development's (OECD) Forum on Harmful Tax Practices that FDII and GILTI operate in tandem to equate the rate of tax imposed on income generated by serving foreign markets, regardless of whether that market is accessed via domestic or foreign operations. As such, FDII does not qualify as an export subsidy in violation of World Trade Organization (WTO) rules. Such a statement represents somewhat of a departure from the usual tenor of Treasury regulations, as it seeks to memorialize the official position of the United States regarding domestic rules through the lens of U.S. obligations to international organizations such as the WTO and OECD. The Final Regulations also eliminate the optional gross income method for apportioning R&E expense, citing the IRS and Treasury's belief that the method produces "inappropriate and distortive results" in certain circumstances.
C. Interaction Between R&E Expense Allocation Rules and Disregarded Payment Reallocation Rules under Treas. Reg. § 1.904-4(f)(vi)
The Final and Proposed Regulations also offer clarifications regarding the operation of the R&E expense allocation and apportionment rules in the context of disregarded transactions between foreign branch owners and foreign branches. In response to the suggestion that GII could improperly include items of gross income that are reallocated to or from a foreign branch R&E service provider under the disregarded payment reallocation rules,6 the IRS and Treasury declined to exclude those amounts from the definition of GII and instead rearticulated the operation of the disregarded payment reallocation rules. Specifically, the Final Regulations note that the reallocation of disregarded amounts between foreign branch owners and foreign branches does not alter the amount of GII (because gross income does not include disregarded service payments), but instead could result in the reassignment of amounts of GII from the general category to the foreign branch category (or vice versa), with the effect of potentially reducing the amount of foreign tax credits available to offset foreign branch income.7
The Proposed Regulations, in an effort to harmonize the treatment of disregarded payments and the allocation and apportionment of the foreign taxes attributable thereto, expand the list of entities to which the disregarded payment reallocation rules apply to include a "non-branch taxable unit," which is defined as an entity that is neither a foreign branch nor a foreign branch owner.8 This expansion is meant to capture inter-foreign branch and inter-foreign branch owner transactions, as well as transactions with disregarded entities that are not foreign branches. Finally, the Proposed Regulations offer an illustration of the operation of the matching principle within the context of intercompany transactions between a member of a consolidated group and a foreign branch of another member of the group and applies a single entity approach to the reattribution of income to and from the foreign branch category.9
D. Applicability Dates
The Final Regulations related to R&E expense are generally applicable to tax years beginning after December 31, 2019.10 A taxpayer may choose to apply Treas. Reg. § 1.861-17 to taxable years beginning before January 1, 2020, provided that they apply the Final Regulations in their entirety.11 If a taxpayer chooses to apply the Final Regulations to a taxable year beginning in 2018, then they must also apply the Final Regulations to the subsequent taxable year beginning in 2019.12 Alternatively, taxpayers may rely on Prop. Treas. Reg. § 1.861-17 (2019) in its entirety, or to prior law, for taxable years beginning after December 31, 2017 and beginning before January 1, 2020.13 Taxpayers who apply either the proposed or final version of Treas. Reg. § 1.861-17 to a taxable year beginning on or after January 1, 2018 and beginning before January 1, 2020 must apply it with respect to all operative Code sections (including both sections 250 and 904).14
Prop. Treas. Reg. §§ 1.904-4(f) and 1.904-6(b)(2) apply to taxable years beginning after December 31, 2019 and ending on or after the date of filing in the Federal Register.15
II. ALLOCATION AND APPORTIONMENT OF STEWARDSHIP EXPENSES – FINAL REGULATIONS
The 2019 Proposed Regulations made several changes to the rules for allocating and apportioning stewardship expense. These rules were subject to substantial criticism, in particular because they could have been interpreted to provide that stewardship expense must be allocated and apportioned to dividends and other income inclusions with respect to foreign affiliate stock, but not U.S. affiliate stock, which would have resulted in an unwarranted overallocation of expense to GILTI and other foreign source income. While the Final Regulations generally retain the structure of the 2019 Proposed Regulations, they provide for the allocation and apportionment of stewardship expense to stock and other ownership interests of U.S. and foreign affiliates, resulting in more reasonable outcomes. That said, technical issues remain.
A. Definition of Stewardship Expenses
The Final Regulations retain the existing definition of stewardship expenses as either duplicative or shareholder activities, as described in the transfer pricing regulations.16 The preamble distinguishes such expenses, which are incurred to steward the business of other entities, from "supportive expenses" that support the business of the taxpayer itself. Under this construct, to the extent the parent of a multinational group engages in business activities directly (or through an unincorporated branch), it may be that a portion of the expenses typically categorized as stewardship expenses should instead be categorized as supportive expenses related to such business activities.
B. Allocation of Stewardship Expenses to Dividends and Other Income Inclusions
The Final Regulations provide that stewardship expense is allocated and apportioned to dividends and other income inclusions with respect to stock, partnership interests, or disregarded entities held by the taxpayer, including members of the taxpayer's U.S. affiliated group.17 The U.S. affiliated group rules, which generally treat a U.S. affiliated group as a single taxpayer, and the exempt income and asset rules, which otherwise could treat affiliated member stock as an exempt asset, do not apply for this purpose.18
The Final Regulations provide that stewardship expense must be allocated to all types of income derived from the ownership of entities, including dividends and shareholder-level income inclusions such as subpart F or GILTI inclusions.19 In response to comments, the Final Regulations clarify that stewardship expenses may be allocated to income derived from a subset of entities to which the expense has a factual connection. Thus, to the extent stewardship expenses are factually connected to entities with business activities in a particular region or business line, such expenses would be allocated to income derived from such entities, and not income derived from other entities.20
C. Apportionment of Stewardship Expenses – Tax Book (or Alternative Tax Book) Value
Stewardship expenses allocated to one or more entities must be apportioned on the basis of the tax book value (or alternative tax book value) of the taxpayer's interest in those entities.21 Comments advocating a more flexible approach to apportionment, including the use of a gross income method, were rejected. While stewardship expenses may be factually connected an indirectly owned entity, apportionment is based on the value of the entities that are owned directly by the taxpayer. Special rules are provided to determine the value of U.S. affiliates and disregarded entities.
D. Applicability Dates
The Final Regulations related to stewardship expense are generally applicable to tax years beginning after December 31, 2019.22 Taxpayers with taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also begin on or before December 31, 2019 should rely on the rules as in effect on December 17, 2019.23
The Final Regulations provide a more mechanical framework for allocating and apportioning stewardship and similar expenses than had been the case under prior law. The Final Regulations make welcome changes to the 2019 Proposed Regulations, providing that taxpayers may allocate stewardship expenses to U.S. affiliate stock and permitting the direct allocation of stewardship expenses to a subset of entities to which the expenses are factually connected. While the tax book value approach to apportionment adopted by the Final Regulations is generally consistent with the approach to apportioning interest expense, the treatment of members of a U.S. affiliated group as separate taxpayers for this purpose can create compliance and technical issues. Taxpayers are not required to determine the tax book value of domestic subsidiaries for purposes of apportioning interest expense, and technical issues may arise to the extent stewardship expenses are incurred by a member of the U.S. affiliated group with respect to sister entities or other entities outside of its ownership chain. It may be possible to minimize or avoid these issues through appropriate categorization of expenses or transfer pricing within the U.S. affiliated group. Taxpayers should review the application of these rules to their particular facts and consider reevaluating their categorization of expenses under prior law.
III. ALLOCATION AND APPORTIONMENT OF DAMAGES PAYMENTS – FINAL REGULATIONS
The Final Regulations maintain the same approach as the 2019 Proposed Regulations for the allocation and apportionment of litigation-related expenses. Generally, damages or settlement awards related to product liability (or provision of services or sales of goods) are allocated to the class of gross income produced by the specific sales of products or services that gave rise to the claim, or to the class of gross income produced by the applicable assets.24 Damages awards related to shareholder suits meanwhile are allocated to all income of the corporation and apportioned based on the relative values of all of the corporation's assets that produce income in the statutory and residual groupings.25 Treasury and the IRS explicitly rejected requests by commentators to provide for a more flexible approach given that certain shareholder claims may have a narrow geographic scope, reasoning that the purpose of direct investor lawsuits is to compensate investors for damages to their investment in the entire company and therefore damages relate to all income-producing activities. This provision of the Final Regulations applies to taxable years beginning after December 31, 2019.26
IV. ALLOCATION AND APPORTIONMENT OF FOREIGN INCOME TAXES – FINAL AND PROPOSED REGULATIONS
The Final Regulations finalize rules that address how to match foreign income taxes with income, generally in accordance with the approach of the 2019 Proposed Regulations, but with some refinements. In addition, Treasury and IRS made further significant changes to the rules pertaining to foreign taxes on disregarded payments by re-proposing these rules in the Proposed Regulations.
Consistent with the 2019 Proposed Regulations, the Final Regulations allocate and apportion foreign tax to items of gross income under foreign law ("foreign gross income") by first assigning items of foreign gross income on which foreign tax is imposed to a statutory or residual grouping, then allocating and apportioning deductions under foreign law to that income, and finally allocating and apportioning the foreign tax among the groupings.27 Items of foreign gross income are assigned to statutory or residual groupings by reference to the "corresponding U.S. item" of income.28 The Final Regulations provide rules for characterizing items of foreign gross income if the taxpayer does not realize or recognize a corresponding U.S. item.
The Final Regulations made welcome changes to the definition of "base differences" in the 2019 Proposed Regulations. These rules are important because base differences are assigned to the residual grouping, and a foreign tax paid by a CFC on such income is therefore not creditable under section 960.29 Under the Final Regulations, base differences include only: death benefits, gifts and inheritances, contributions to capital, money or property in exchange for stock under section 1032, and money or property in exchange for a partnership interest under section 721.30 The 2019 Proposed Regulations had included return of capital distributions under section 301(c)(2) on the exclusive list of base differences, but in response to comments, the Final Regulations provide that a foreign law dividend that gives rise to a return of capital distribution under section 301(c)(2) is not treated as a base difference but is instead characterized based on the assets of the distributing corporation.31
Treasury and IRS did not finalize the portion of the 2019 Proposed Regulations that address foreign taxes on disregarded payments between a foreign branch and its owner. The 2019 Proposed Regulations diverged from the treatment of disregarded payments in the context of the foreign branch category and instead provided that foreign gross income arising from a disregarded payment from a foreign branch to its owner was characterized based on the tax book value of the branch's assets, and that foreign gross income arising from a disregarded payment from a foreign branch owner to its foreign branch was assigned to the residual grouping. Treasury and IRS received comments that these results were inappropriate, in particular because foreign taxes on payments of interest, royalties, or services fees by a foreign branch owner to its foreign branch should be creditable and not assigned to the residual grouping.32
In response to these comments, the new Proposed Regulations provide for comprehensive and detailed rules addressing the allocation and apportionment of foreign income taxes relating to disregarded payments. These rules take disregarded payments into account in matching foreign taxes to items of income for U.S. purposes, and the result in many cases is to better align foreign taxes with income in the statutory groupings for purposes of claiming a U.S. foreign tax credit. In many ways, the disregarded payment rules in the Proposed Regulations follow the principles adopted in the 2019 Final Regulations relating to foreign branch category income and in the 2020 Final Regulations on the GILTI high-tax exclusion.33 Mechanically, the Proposed Regulations introduce the concept of a "taxable unit." In the case of a foreign corporation, a taxable unit is the same as a "tested unit," a term is generally defined in the GILTI high-tax regulations to mean a CFC and its disregarded entities or branches that are treated as tax residents in the foreign country.34 The Proposed Regulations provide that certain disregarded payments made to or by a taxable unit are considered "reattribution payments" and result in the reattribution of U.S. gross income to each taxable unit.35 The rules are highly complex and should be studied carefully given the importance of allocating and apportioning current-year foreign taxes to CFC income in the context of GILTI and subpart F, but the overall effect of these rules is to take into account disregarded payments in a way that better matches the foreign tax with income in the statutory groupings from a U.S. tax perspective.
The Proposed Regulations request comments on aspects of the rules for allocating and apportioning foreign taxes, including: whether different rules are needed for the treatment of foreign gross basis taxes paid by taxable units that make disregarded payments; whether an approach other than the asset method should be used to assign foreign taxes on remittances; and the appropriate treatment of foreign income taxes paid or accrued in connection with the sharing of losses in a foreign law group-relief regime.
The Final Regulations relating to allocation and apportionment of foreign taxes are applicable to tax years beginning after December 31, 2019.36 The provisions of the Proposed Regulations relating to foreign taxes on disregarded payments are proposed to apply to tax years that begin after December 31, 2019 and end on or after the date the Proposed Regulations are filed in the Federal Register.37
V. FOREIGN TAX REDETERMINATIONS – FINAL REGULATIONS
The Final Regulations largely keep the approach of the 2019 Proposed Regulations by requiring U.S. taxpayers to file amended returns for the affected year to account for changes to the foreign tax credit as a result of foreign tax redeterminations under section 905(c). Taxpayers are required to file an amended return within the due date of the original return of the year in which the foreign tax determination occurs, regardless of the amount of the foreign tax redetermination.38 Treasury and the IRS explicitly rejected a regulatory de minimis threshold, requested by commentators, noting that recharacterizing prior year taxes as current year taxes would have substantive effects on various calculations, including GILTI and subpart F inclusions. Requests from commentators for a longer period to file an amended return (i.e., up to three years) or the ability to file a statement with a current year return rather than filing an amended return were likewise rejected. The final regulations do include a transition rule for foreign tax redeterminations occurring in taxable years ending on or after December 16, 2019 and before the date of the final regulations that offer taxpayers an additional year to file the required notifications.39 In addition, the preamble to the Final Regulations states that the IRS and Treasury continue to study whether new processes or forms can be developed to streamline the filing requirements, and the Final Regulations provide the IRS with the authority to prescribe alternative notification requirements through subregulatory guidance such as forms or publications.
For taxpayers under LB&I examination, the 2019 Proposed Regulations permitted taxpayers with a downward adjustment to the amount of foreign tax paid or accrued to notify the IRS with a signed statement describing the foreign tax redetermination. The Final Regulations permit such LB&I taxpayers to use this alternate notification method if there is an upward adjustment in the amount of foreign tax paid or accrued as well.40 However, the alternate notification method is still only available to LB&I taxpayer for the years under exam.
The TCJA repealed the section 902 pooling rules and the related rules permitting foreign tax pool adjustments to account for redeterminations of foreign tax paid by foreign corporations and deemed paid by their corporate U.S. shareholders. The 2019 Proposed Regulations included a transition rule providing that post-2017 redeterminations of pre-2018 foreign income taxes of foreign corporations must be accounted for by adjusting the foreign corporation's taxable income and earnings and profits. The Final Regulations also contain a new election that permits a foreign corporation to treat all foreign tax redeterminations that relate to pre-2018 taxable years and occur after the date the regulations are published as if they occurred in the foreign corporation's last taxable year beginning before January 1, 2018.41 The election is irrevocable and should be made by a foreign corporation's controlling domestic shareholders.42
The Final Regulations relating to foreign tax redeterminations generally apply to foreign tax redeterminations occurring in tax years ending on or after December 16, 2019, and to foreign tax redeterminations of foreign corporations occurring in tax years that end with or within a tax year of a U.S. shareholder ending on or after December 16, 2019.43
VI. CREDITABILITY OF FOREIGN TAXES UNDER SECTIONS 901 AND 903 – PROPOSED REGULATIONS
Section 901 allows a credit for foreign income taxes, and section 903 provides that such taxes include a tax in lieu of a generally imposed foreign income tax. Longstanding regulations have provided guidance on whether (1) a foreign levy is a creditable foreign income tax, generally testing whether a foreign levy is likely to reach net gain in the normal circumstances in which it applies; and (2) a foreign levy is a creditable "in lieu of" tax, generally testing whether the foreign levy is in substitute for, rather than in addition to, an otherwise generally applicable foreign income tax. These statutory rules are supplemented by the provisions of U.S. income tax treaties, which often provide that specifically identified foreign taxes are creditable. The current regulatory rules, which have been in place for decades, are based on, and have been interpreted by, a substantial body of caselaw. The current rules are intended to ensure that a foreign tax credit is provided for foreign levies that are applied to a base that is broadly comparable to the U.S. income tax base and therefore constitute an income tax, rather than a tax on (for example) consumption, assets, or turnover, and for foreign levies that are imposed as a substitute for such foreign income taxes.
The Proposed Regulations propose a new jurisdictional nexus requirement, under which a foreign levy would be treated as a creditable foreign tax only if foreign law requires a sufficient nexus between the foreign country and the taxpayer's activities or investments that give rise to the income or other amounts being taxed. Other changes are made to the constituent elements of the net gain requirement, and to the determination of whether a foreign tax constitutes one or more separate foreign levies tested against these criteria.
While the proposed changes are targeted at "novel extraterritorial" taxes such as digital services taxes, diverted profits taxes, and equalization levies, the changes are profound and could threaten the creditability of other categories of foreign taxes that are not covered by existing treaties. Conceptually, the jurisdictional nexus requirement is a departure from longstanding principles and the statutory structure of the foreign tax credit, which in general have provided a credit against U.S. tax for foreign income taxes subject to specific statutory limitations intended to ensure that no credit is provided against the U.S. tax on U.S. source income. The preamble requests comments on the new requirement and other aspects of the proposed rules. Taxpayers affected by these proposed regulations would be well advised to comment.
A. New Jurisdictional Nexus Requirement
The Proposed Regulations add a new jurisdictional nexus requirement.44 Under this requirement, a foreign levy would be an income tax in the U.S. sense and therefore, be treated as a creditable foreign income tax, only if foreign law requires a sufficient nexus between the foreign country and the taxpayer's activities or investments that give rise to the income being taxed. Different rules are provided for foreign taxes imposed on nonresidents and on residents, defined with reference to foreign tax law. While reference is made in the preamble to international norms for jurisdictional nexus, the proposed rules test jurisdictional nexus against analogous U.S. tax law principles for allocating profit between associated enterprises, for allocating business profits of nonresidents to a taxable presence in the foreign country, and for taxing cross-border income based on source.
In the case of foreign taxes imposed on the business profits of nonresidents, the amount of income subject to tax must be based on the income attributable, under reasonable principles, to the nonresident's activities located in the foreign country.45 Foreign levies imposed on a base that accounts for destination-based criteria, such as the location of users or customers, will not satisfy this requirement. Attribution of income under reasonable principles includes attribution consistent with U.S. law for taxing income effectively connected to a U.S. trade or business or business profits attributable to a permanent establishment.
In the case of foreign taxes imposed on payments to nonresidents based on that income arising from sources in the foreign country, the applicable sourcing rules must be reasonably similar to the sourcing rules that apply for U.S. income tax purposes.46 With respect to service fees, the income must be sourced based on the place of performance of the services, not the location of the service recipient.
In the case of foreign taxes on gains from dispositions of property by nonresidents (other than dispositions related to the conduct of activities within the foreign country), such gains must be with respect to real property situated in that country, or "movable" property forming part of the business property of a taxable presence in the foreign country (or with respect to entities to the extent the gains are attributable to such real or movable property).47
In the case of foreign taxes on the business income of resident taxpayers that engage in transactions with related parties resident in other countries, the jurisdictional nexus requirement is met only if the foreign tax law's transfer pricing rules are consistent with arm's length principles.48 Transfer pricing rules that take into account as a significant factor destination-based criteria, such as the location of customers or users, will not satisfy the jurisdictional nexus requirement. Comments are requested on whether special rules are needed to address foreign transfer pricing rules that allocation profits on a formulaic basis.
B. Changes to the Net Gain Requirement
The Proposed Regulations would make changes to the constituent elements of the current law net gain requirement: the realization, gross receipts, and net income (or cost recovery) requirements. In general, the proposed regulations would refocus the analysis away from a holistic evaluation of whether the foreign levy meets these requirements in the normal circumstances in which the tax applies, the standard in longstanding regulations that is based on, and has been applied in, a substantial body of caselaw. The proposed regulations instead provide objective rules that must be met based on the terms of the foreign tax law.49 These objective rules reference U.S. tax law as their touchstone. Accordingly, for example, a denial of deductions for interest, payments on hybrid instruments, or payments that implicate public policy concerns (e.g., penalties) will not violate the net income requirements to the extent the foreign law rules are similar to the analogous U.S. law rules. To the extent that foreign law denied deductions for payments that are generally deductible under U.S. principles, however, the net income requirement may not be met. The effect of these changes will be to narrow the scope of creditable foreign income taxes to taxes that mechanically resemble the U.S. income tax.
C. Separate Levy Rules
A foreign levy that fails to meet the jurisdictional nexus requirement or the net gain requirement is not a creditable foreign income tax. The proposed regulations provide new, mechanical rules for determining whether a foreign levy is separate from another foreign levy for purposes of determining whether the levy meets the requirements of section 901 (or section 903).50 Foreign levies imposed by different taxing authorities are always treated as separate levies, even if the taxes are imposed on the same base.51 Foreign levies imposed by a single tax authority on different bases are treated as separate levies, even if the same income is included in each base, if the taxable bases are not combined.52 A foreign levy imposed on nonresidents is treated as a separate levy from taxes imposed on residents.53 Finally, a gross-basis withholding tax imposed on nonresidents is treated as a separate levy with respect to each class of gross income to which it applies.54 These rules are intended to facilitate the separate analysis of the extraterritorial aspect of generally applicable taxes under the new jurisdictional nexus requirement; thus, for example a foreign withholding tax may not be creditable as applied to fees for digital or technical services, but may be creditable as applied to interest or dividends.
D. Section 903 "In Lieu of" Taxes
The Proposed Regulations provide new rules related to determining whether a foreign tax in lieu of a generally applicable foreign income tax (an "in lieu of tax") is creditable. Among other things, longstanding regulations require that such a tax be imposed in substitution for, and not in addition to, one or more foreign income taxes that are otherwise generally imposed.
The Proposed Regulations revise the substitution requirement, providing four tests that must be met for a tested foreign tax to qualify as an in lieu of tax.55 First, a separate levy that is a foreign income tax under the section 901 regulations must be generally imposed by the same country.56 Second, neither this generally imposed income tax nor any other foreign income tax applies to income related to the items that form the basis of the tested foreign tax ("excluded income").57 Third, but for the existence of the tested foreign tax, the excluded income would be subject to tax under a generally imposed foreign income tax.58 Fourth, if the generally imposed foreign income tax were to apply to excluded income, it would either continue to qualify as a foreign income tax under the section 901 regulations (including the jurisdictional nexus requirement), or would constitute a separate levy that would so qualify.59
The Proposed Regulations provide for special rules that apply the substitution requirement to certain covered withholding taxes.60 In particular, covered withholding taxes must satisfy the jurisdictional nexus requirement described in the proposed section 901 regulations.
E. Applicability Date
The proposed jurisdictional nexus requirement and associated changes to the foreign tax credit regulations are proposed to apply prospectively, to taxable years beginning on or after the publication of final regulations.61 No inference is intended as to whether novel extraterritorial taxes such as digital services taxes are creditable under current law.
F. Comments Requested
The proposed jurisdictional nexus requirement would represent a profound change to the criteria for determining whether a foreign tax that is not covered by an income tax treaty is a creditable foreign income tax. Conceptually, the jurisdictional nexus requirement is a departure from longstanding principles and the statutory structure of the foreign tax credit. While the proposed rules are aimed at novel taxes such as digital services taxes, they could threaten the creditability of other longstanding and prevalent categories of foreign taxes, such as withholding taxes on fees for technical services. The preamble requests comments on the new requirement, including the treatment of foreign income taxes with formulaic transfer pricing rules, the impact of the new requirement on taxes other than novel extraterritorial taxes, and alternative approaches that would achieve desired policy objectives. The preamble also requests comments on whether the rules applicable to dual capacity taxpayers (which distinguish foreign levies paid for a specific economic benefit, such as the right to extract natural resources, from foreign levies that are considered taxes) are necessary as a result of the new jurisdictional nexus requirement. Finally, the preamble acknowledges that digital service taxes are a topic of current policy discussions at the OECD, and that the outcome of those discussions could result in a reconsideration of these regulations. Taxpayers affected by these proposed regulations would be well advised to comment.
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1REG-106013-19; 85 F.R. 19858 (April 8, 2020).
2Treas. Reg. § 1.861-17(b)(2).
3Treas. Reg. § 1.861-17(b)(1).
4IRC § 250(b)(3)(A)(ii), Treas. Reg. § 1.250(b)-1(d)(2).
5Treas. Reg. § 1.861-17(c).
6Treas. Reg. § 1.904-4(f)(2)(vi). These rules were finalized in December 2019.
7Treas. Reg. § 1.861-17(b)(2). Interestingly, the Final Regulations acknowledge the disparity in the calculation of amounts of general and foreign branch category GII when applying the R&E expense allocation and apportionment rules to disregarded branches and CFCs, but do not make any attempt to remedy it. Instead, the Final Regulations attribute the disparity to the disregarded payment reallocation rules' treatment of sales and services income as two different characters of gross income, and conclude that it would be inappropriate to "override the [disregarded payment reallocation rules'] characterization of gross income" by adjusting the R&E expense allocation and apportionment rules.
8Prop. Treas. Reg. §§ 1.904-4(f)(2)(vi)(G), 1.904-4(f)(3), and 1.904-6(b)(2)(i)(B).
9Treas. Reg. § 1.904-4(f)(4)(xv), Example 15. This approach yields the same result that would be obtained if the transaction had taken place directly between a foreign branch owner and its disregarded foreign branch. This result is to be expected, given the fact that in the consolidated group context, the transaction is regarded for federal income tax purposes. Cf. Prop. Treas. Reg. § 1.904-4(f)(4)(xii), Example 13.
10Treas. Reg. § 1.861-17(h).
12See Preamble to TD 9922.
15Prop. Treas. Reg. § 1.904-4(q)(3); Prop. Treas. Reg. § 1.904-6(g).
16See Treas. Reg. § 1.861-8(e)(4)(ii)(C) (referencing Treas. Reg. § 1.482-9(l)(3)(iii) and (iv)).
17Treas. Reg. § 1.861-8(e)(4)(ii)(A).
18Treas. Reg. § 1.861-8(e)(4)(ii)(C).
19Treas. Reg. § 1.861-8(e)(4)(ii)(B).
21Treas. Reg. § 1.861-8(e)(4)(ii)(C).
22Treas. Reg. § 1.861-8(h)(2).
24Treas. Reg. § 1.861-8(e)(5)(ii).
25Treas. Reg. § 1.861-8(e)(5)(iii).
26Treas. Reg. § 1.861-8(h)(2).
27Treas. Reg. § 1.861-20(c).
28Treas. Reg. § 1.861-20(d).
29Treas. Reg. § 1.960-1(e).
30Treas. Reg. § 1.861-20(d)(2)(iii)(B).
31Treas. Reg. § 1.861-20(d)(3)(1)(B).
32For a discussion of the disregarded payment rules in the 2019 Proposed Regulations and related issues, see Layla J. Asali, Regarding Disregarded Payments, Int'l Tax J. 29 (Sep.-Oct. 2020).
33Treas. Reg. § 1.904-4(f)(2)(vi), § 1.951A-2(c)(7)(ii)(B)(2); see also Prop. Treas. Reg. § 1.954-1(d)(1)(iii)(B) (the 2020 Proposed Regulations providing for a unified high-tax exclusion for GILTI and Subpart F adopt a similar approach towards disregarded payments).
34Prop. Treas. Reg. § 1.861-20(d)(3)(v)(E)(9). In other cases, a taxable unit means a foreign branch, foreign branch owner, or non-branch taxable unit.
35Prop. Treas. Reg. § 1.861-20(d)(3)(v)(B).
36Treas. Reg. § 1.861-20(i).
37Prop. Treas. Reg. § 1.861-20(i).
38Treas. Reg. § 1.905-4(b)(1).
39See Treas. Reg. § 1.905-4(b)(6).
40Treas. Reg. § 1.905-4(b)(3).
41Treas. Reg. § 1.905-5(e)(1).
42Treas. Reg. § 1.905-5(e)(2)(ii).
43Treas. Reg. §§ 1.905-3(d), 1.905-4(f).
44Prop. Reg. § 1.901-2(c).
45Prop. Reg. § 1.901-2(c)(1)(i).
46Prop. Reg. § 1.901-2(c)(1)(ii).
47Prop. Reg. § 1.901-2(c)(1)(iii).
48Prop. Reg. § 1.901-2(c)(2).
49See Prop. Reg. § 1.901-2(b).
50Prop. Reg. § 1.901-2(d)(1).
51Prop. Reg. § 1.901-2(d)(1)(i).
52Prop. Reg. § 1.901-2(d)(1)(ii).
53Prop. Reg. § 1.901-2(d)(1)(iii).
55Prop. Reg. § 1.903-1(c)(1).
56Prop. Reg. § 1.903-1(c)(1)(i).
57Prop. Reg. § 1.903-1(c)(1)(ii).
58Prop. Reg. § 1.903-1(c)(1)(iii).
59Prop. Reg. § 1.903-1(c)(1)(iv).
60Prop. Reg. § 1.903-1(c)(2).
61See Prop. Reg. §§ 1.901-2(h) and 1.903-1(e).
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