Prior to the end of 2021, the U.S. Treasury Department issued final foreign tax credit regulations under Treasury Regulation Section 1.901-2,1
dramatically modifying the analysis
for determining whether a foreign levy is a creditable foreign tax. The regulations apply to tax years beginning after Dec. 28, 2021, and finalize proposed regulations issued in November 2020.
The changes result from foreign countries
enacting new digital service taxes (DSTs) that primarily affect technology companies that have no physical presence or other traditional nexus with the taxing country. In essence, a DST is a tax based on where the customer is. For example, when a customer
makes a purchase over the internet, that transaction can be subject to the DST. This is not a value-added tax (VAT), but rather a tax in addition to VAT meant to approximate an income tax on the online sale.
This column provides
insight on some of the more salient issues arising from the U.S. government’s response in Section 1.901-2.
In brief, Treasury is not going to allow U.S. taxpayers to credit DSTs. It does not want to subsidize foreign jurisdictions
at the expense of the U.S. tax revenue generating system. Here is what they say in the preamble to the regulation:
“[The purpose of the foreign tax credit] is served most appropriately if there is substantial conformity in
the principles used to calculate the base of the foreign tax and the base of the U.S. income tax. This conformity extends not just to ascertaining whether the foreign tax base approximates U.S. taxable income ... but also whether there is sufficient nexus
between the income that is subject to the tax and the foreign jurisdiction imposing the tax.”
The new foreign tax credit regulations change the “net gain” requirement by creating a new attribution requirement and
modifying that of cost recovery. The realization and gross receipts requirements remain relatively unchanged compared with prior regulations. For a foreign tax to satisfy the net gain requirement, the regulations outline four requirements: realization,
gross receipts, cost recovery, and attribution. These are much stricter than the prior three-part test, and will result in U.S. taxpayers claiming fewer foreign tax credits.
The new attribution requirement was added to ensure that
U.S. taxpayers claim only foreign tax credits on foreign taxes paid that have sufficient nexus to the income being taxed. The attribution requirement provides two primary ways that a foreign tax conforms with U.S. tax nexus principles:
- Activities-based attribution rule – Establishes that the taxing country has sufficient nexus with the taxed income by proving that such income is attributable to nonresident’s activities in that country.
- Sourcing attribution rule – Demonstrates that the foreign tax was imposed based on sourcing rules that are similar to U.S. sourcing rules.2
The new regulations explain that the activities-based attribution rule is satisfied if the foreign tax law attributes gross receipts and expenses to a taxpayer under principles that are similar to the U.S. effective connected income (ECI) rules contained
in Section 864(c). The attribution rules of the ECI regime are based on activities (business activities test), assets (assets-use test), and source. Treasury has indicated that taking into account the location of the customers, users, or any similar destination-based
criterion as a significant factor is not a reasonable principle. This effectively shuts down the possibility that a DST would satisfy the activities attribution rule.
A foreign tax must also comply with the sourcing attribution
rule if the foreign tax is imposed based on sourcing rules reasonably similar to those under U.S. tax principles. This rule is more applicable to withholding taxes.
DSTs also may be imposed on those with operations in the tax-levying foreign country. Treasury is concerned about countries imposing other types of taxes where the taxable income is determined under non-arm’s-length principles,
such as a diverted profits tax or levies on income earned by affiliates related to the taxpayer. The regulations require that receipts must be determined using arm’s-length principles without taking into account the location of customers, users,
or any similar destination-based criteria as a significant factor. This puts at risk the entire tax if a portion is based, for example, on certain fixed margins that are not based on arm’s-length principles.
The new regulations
also significantly modify the cost-recovery requirement and go beyond DSTs. They will impact non-DST levies that had previously qualified as foreign tax credits under former regulations. For example, under prior regulations a foreign tax would satisfy
the cost-recovery requirement if the foreign tax law permitted the taxpayer to reduce taxable income by either “significant” costs and expenses or an approximation of significant costs and expenses that was likely to reach net income in normal
This prior test was broad, but it reflected the reality that foreign countries are free to write their own income tax laws and that U.S. taxpayers need not perform a detailed analysis into the intricacies of a foreign
tax calculation to determine creditability. Treasury’s new regulations eliminate this broad guideline and instead provide strict requirements that must be satisfied for a foreign income tax to meet the cost-recovery requirement. Unless an exception
applies, a foreign tax can satisfy the cost-recovery requirement only if the foreign tax law permits the taxpayer to recover capital expenditures (through depreciation, amortization, or immediate expensing), interest expense, rent and royalty costs, payments
for wages and services, and research and experimental costs. In essence, U.S. taxpayers and their advisers must overlay how the United States taxes income over how the foreign jurisdiction taxes income to ensure the foreign jurisdiction’s mechanics
conform with the U.S. tax system. For example, many countries do not permit deductions for stock options, which puts the entire tax at risk from qualifying as a creditable foreign tax credit from that country.
A Treasury official
indicated in May 2022 that additional guidance will be issued to supplement the new regulations. They are expected to focus on a limited safe harbor for royalties.3
Treasury issued the new foreign tax credit regulations
to curtail credits on DSTs, but they were written so broadly they put at risk credits on other foreign taxes that had been creditable, including withholding taxes. Advisers need to become familiar with these new rules and analyze how the new rules apply.
Not only are the new rules complex, but the reality is taxpayers and their advisers may find that foreign taxes that were previously creditable no longer are. 1 All section references are to the Internal Revenue Code (IRC), as amended, or related Treasury Regulations. Regulations were also issued at this same time for withholding and substitute tax payments under Section 1.903-1, disregarded payment rules under Section 1.861-20, compulsory tax rules under Section 1.902-1, and foreign tax credit timing rules under Sections 901 and 905, which are not discussed herein.
2 If the foreign income tax does not satisfy the attribution requirement, the foreign tax may still be creditable under an applicable income tax treaty coordination rule. There is also a situs-of-property attribution rule. These rules are not discussed herein.
3 The United States has a fairly unique sourcing rule for royalties that is not common for how foreign jurisdictions source royalties. The United States sources royalties where the intangible property is used/exploited; most foreign jurisdictions source royalties based on the residence of the person paying the royalty. Treasury recently provided additional guidance addressing cost recovery issues and disregarded distributions in the foreign tax credit context.
Andrew M. Bernard Jr., CPA, is managing director for Andersen in Philadelphia and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.