By Patricia Brandstetter and Jonathan D. Grossberg
Final regulations, issued December 28, 2021 (TD 9959), significantly change longstanding principles for determining taxes eligible for the foreign tax credit. The regs limit creditability to foreign income taxes that largely conform to U.S. tax laws, including with respect to the sourcing of income, allowable deductions, and application of the arm’s-length principle. Tax treaties might preserve creditability in limited circumstances.
The new rules for creditability of foreign income taxes apply to foreign taxes paid or accrued in tax years beginning on or after December 28, 2021.
Observation: The Alliance for Competitive Taxation, a coalition of some of the biggest U.S. corporations, including Coca-Cola and Google, expressed concern as to whether Brazil’s income tax, or services and royalty withholding taxes imposed in countries including India and Mexico, are creditable under the final regs. Moreover, nonresident capital gains taxes imposed by many countries on the disposition of stock in a foreign entity may not be creditable.
New attribution requirement.
This requirement aims to ensure that destination-based taxes (such as digital services levies, which are based on a company’s digital, rather than physical, presence) aren’t creditable taxes, as they lack sufficient nexus to the taxing jurisdiction. The required connection between a creditable foreign income tax and the foreign jurisdiction imposing the tax depends on whether the tax is levied on residents or nonresidents of the taxing jurisdiction.
Tax levied on residents must meet arm’s-length requirement.
For residents of a foreign country imposing the tax, the regs require that any allocation made under the foreign country’s transfer pricing rules must be determined under arm’s-length principles, without taking into account as a significant factor the location of customers, users, or similar destination-based criteria.
Observation: Transfer pricing rules that are consistent with the arm’s-length standard under Code Sec. 482, or with the Organization for Economic Cooperation and Development’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, will satisfy this requirement.
Caution: It is irrelevant whether taxpayers apply arm’s-length principles in their transactions or even engage in related-party transactions. Creditability is denied where the foreign country’s transfer pricing rules, as generally applicable to all taxpayers, don’t adopt arm’s-length principles, or where those rules use destination-based criteria.
Tax levied on nonresidents must meet requirements that depend on whether it is based on activities, source, or situs.
For a foreign tax based on activities to be creditable, gross receipts and cost must be attributable, based on reasonable principles, to the nonresident’s activities in the foreign country, including functions, assets, and risks. The tax may not be based merely on the location of customers, users, or similar destination-based criteria.
For a foreign tax based on income arising from sources within the foreign country, the regs require that foreign tax laws be reasonably similar to U.S. sourcing rules. Services income must be taxed where the services are performed, not where the recipient is located. Royalty income must be sourced to the place of use or right of use.
Foreign taxes based on situs (the location of property) must be reasonably similar to U.S. rules and may be levied only on
- Gains on the disposition of real property located in the foreign country (or of an interest in an entity that resides in the foreign country and owns real property there), and
- Dispositions of business property (or of an interest in a partnership or other pass-through entity that has a taxable presence in the foreign country, to the extent that the gains are attributable to the entity’s business property in that foreign country).
Cost recovery requirement replaces net income requirement.
A foreign tax that is based on gross receipts is creditable only if the foreign country provides cost recovery (i.e., deductions) for costs and expenses, including capital expenditures, interest (excluding limitations similar to Code Sec. 163(j)), rents, royalties, wages or payments for services, and research and experimentation. The character of a deduction is determined under foreign law. Foreign tax law satisfies this requirement even when deductions are disallowed for all or a portion of an expense, provided that the disallowance is consistent with principles underlying disallowances required by the Code.
Observation: For example, the foreign tax may limit interest deductions so as not to exceed 10% of a reasonable measure of taxable income, based on principles similar to those underlying Code Sec. 163(j).
Caution: If a foreign tax law disallows the deduction of one or more significant costs or expenses, and such disallowance is not consistent with deduction limitations under the Code, it appears that the entire foreign tax is not creditable for any taxpayer, regardless of whether the disallowance is relevant in a taxpayer’s specific circumstances.
Tax treaties can preserve foreign tax credit eligibility.
The regs provide a treaty coordination rule, which clarifies that a foreign levy that is treated as an income tax under an income tax treaty between the U.S. and the foreign country imposing the tax is a foreign income tax if paid by a U.S. citizen or resident (as determined under the treaty) that elects benefits under the treaty. Effectively, the rule provides that where a foreign levy does not meet the requirements under the regs, it might still be creditable if
- An income tax treaty is in effect between the U.S. and the foreign country,
- The foreign levy is an income tax under the Relief from Double Taxation article of the treaty (i.e., a tax referred to in the treaty’s Taxes Covered article), and
- The tax is paid by a U.S. citizen or resident that is eligible for a credit against U.S. income taxes under the Relief from Double Taxation article and elects benefits under the treaty.
Observation: To elect benefits under a tax treaty, a taxpayer must generally disclose the treaty-based return position, pursuant to Code Sec. 6114, by attaching Form 8833 , Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), to the taxpayer’s return.
Caution: A tax treaty between the U.S. and a foreign country does not provide relief if the foreign levy is paid by a controlled foreign corporation (CFC) of a U.S. parent company, rather than paid directly by the U.S. parent company, because the CFC is not a U.S. resident eligible to elect benefits under that tax treaty.
Observation: To navigate the impact of these changes to the creditability rules for foreign income taxes, taxpayers should:
- Identify income (or income equivalent) taxes paid to foreign jurisdictions,
- Evaluate whether such taxes remain creditable under the final regs, and
- Determine whether an income tax treaty between the U.S. and the foreign jurisdiction preserves creditability for a tax that might otherwise fail the requirements for creditability under the final regs.
To continue your research on more on foreign income taxes that qualify for the foreign tax credit, see FTC 2d/FIN ¶O-4200 et seq. For the application of tax treaties and required disclosure of a treaty-based return position, see FTC 2d/FIN ¶O-15000 et seq.
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