Newly Proposed Foreign Tax Credit Regulations Offer Potential Relief on Cost-Recovery Requirement

Taxpayers and advisers have complained that the 2022 foreign tax credit (FTC) final regulations are overly broad and create uncertainty as to what qualifies as an FTC. The U.S. Treasury issued a new set of proposed FTC regulations (REG-112096-22) on Nov. 22, 2022, that modifies and clarifies certain items contained in the earlier 2022 FTC final regulations.¹ The new regulations may provide some relief by creating a safe harbor that relaxes the cost-recovery requirement. Additionally, a single-country exception was added for royalties, permitting taxpayers to structure or amend their royalty agreements so foreign taxes withheld on royalty payments may qualify as a creditable foreign income tax.²

Background

The 2022 FTC final regulations were designed to not permit a credit for the new digital service taxes that had been enacted in many foreign jurisdictions. The cost-recovery requirement, for instance, requires that the tax base for the calculation of a foreign tax permits the recovery of significant costs and expenses attributable, under reasonable principles, to the gross receipts included in the tax base. It further provides, among other things, that foreign tax law is considered to permit the recovery of significant costs and expenses, even if recovery of certain significant costs and expenses are disallowed in whole or in part, if such disallowance is consistent with any principle underlying the disallowances required under the Internal Revenue Code (referred to herein as the principles-based exception). In many cases, this principles-based exception creates significant uncertainty in determining whether a foreign tax qualifies as a foreign tax credit for U.S. tax purposes.

The source-based attribution requirement in the 2022 FTC final regulations, as it relates to the payment of royalties, meets the attribution requirement only if a foreign tax law’s sourcing rules are reasonably similar to the sourcing rules that apply under U.S. federal income tax principles. This means that the foreign tax law must source royalties based on the place of use, or the right to use, of the intangible property (IP), consistent with how the Internal Revenue Code sources royalty income. This seems unlikely, because most foreign jurisdictions source royalties based on the residence of the payor of the royalties not where the IP is exploited.

The Proposed FTC Regulations

The proposed regulations retain the general cost recovery requirement under the 2022 FTC final regulations, but provide that the relevant foreign tax law need only permit recovery of substantially all of each item of significant cost or expense. Consistent with the general approach of the 2022 FTC final regulations, whether a foreign tax permits recovery of substantially all of each item of significant cost or expense is determined solely on the terms of the foreign tax law.

The proposed FTC regulations provide a new safe harbor for the purposes of applying the cost recovery requirement. Under the safe harbor, a disallowance of a stated portion of an item (or multiple items) of significant cost or expense does not prevent a foreign tax from satisfying the cost recovery requirement if the portion of the item (or items) that is disallowed does not exceed 25%. This safe harbor also permits the foreign tax law to cap deductions of a single item of significant cost or expense, or multiple items that relate to a single category of per se significant costs and expenses, so long as the cap, based solely on the terms of the foreign tax law, is not less than 15% of gross receipts, gross income, or a similar measure, or, in the case of a cap based on a percentage of taxable income or a similar measure, the cap is not less than 30%.³ Importantly, if the foreign cost disallowance does not meet the safe harbor or otherwise permit recovery of substantially all of each item of significant cost or expense, the principles-based exception in the 2022 FTC final regulations would then need to be analyzed to determine whether the foreign tax could still satisfy the cost recovery requirement.

The proposed FTC regulations provide an additional exception relating to the attribution requirement for royalties. More specifically, the proposed regulations provide that a tested foreign tax satisfies the source-based attribution requirement if the tax meets either the source-based attribution requirement (which is unlikely, unless an income tax treaty permits the credit) or a new exception referred to as the single-country exception applies.

In general, the single-country exception applies when the income subject to the tested foreign tax is characterized as gross royalty income and the payment giving rise to such income is made pursuant to a single-country license.

A payment is made pursuant to a single-country license if the terms of the written license agreement characterize the payment as a royalty and limits the territory of the license to the foreign country imposing the tested foreign tax. However, a payment (or portion of a payment) may be treated as made pursuant to a single-country license, even if the written agreement does not limit the territory of the license to the foreign country imposing the tax or provide for payments in addition to those for the use of intangible property. The agreement would have to separately state the portion of the payment subject to the tested foreign tax that is characterized as a royalty is part of the territory of the license that is solely within the foreign country imposing the tax. The proposed FTC regulations also include an anti-abuse rule if a taxpayer tries to misstate the territory in which the intangible property is used or overstates the amount of the royalty with respect to the part of the territory of the license that is solely within the foreign country imposing the tax.

In general, a taxpayer cannot qualify for the single-country exception without satisfying the documentation requirement in the proposed FTC regulations. The agreement must be executed no later than the date on which the royalty is paid. However, recognizing that the single-country exception is proposed to be applicable to periods preceding the release of this notice of proposed rulemaking, a special transition documentation rule is provided for royalties paid on or before May 17, 2023. In that case, to satisfy the documentation requirement, the agreement must be executed no later than

May 17, 2023, and the agreement must state (whether in the terms of the agreement or in recitals) that royalties paid on or before the execution of the agreement are considered paid pursuant to the terms of the agreement. The proposed FTC regulations include additional details regarding the documentation requirements.

The Takeaway

Practically speaking, the changes are helpful; the reality, however, is taxpayers and their advisers still need to understand precisely how foreign tax law applies to foreign income and will need to undertake significant detailed analysis and calculations under the foreign law to determine if the new safe harbors are met under the proposed FTC regulations. The single-country exception for royalties seems to have limited application and requires amending existing royalty agreements by May 17, 2023. This can be difficult to accomplish in practice, particularly among unrelated parties. Taxpayers and advisers must continue to monitor these very fluid FTC rules for additional potential changes.

¹ The new guidance can be relied upon with the filing of 2022 calendar year tax returns. This article is a follow up to the article in the fall 2022 Pennsylvania CPA Journal “New Regs to Counter Foreign DST Credit May Kill Other Foreign Credits.”

² There was also a change made in the area of disregarded payments and how to attribute the foreign tax associated with those payments which is not discussed herein.

³ This new exception seems to be geared toward potentially permitting German Trade Tax to qualify as an FTC.