On Sept. 29, 2020, the U.S. Treasury Department and the IRS released a new set of final regulations (T.D. 9922; the Final Regulations) and proposed regulations (REG-101657-20; the Proposed Regulations) covering the determination of foreign tax credits (FTCs) under the Internal Revenue Code (IRC). While the Final Regulations and Proposed Regulations respectively provide a number of clarifications pertaining to FTCs as summarized below, a key issue addressed was the creditability of digital services taxes. Treasury took a firm stance in the Proposed Regulations that digital taxes which are not based on a concept of nexus should not qualify as a creditable income tax.
Numerous countries in the EU and across the world have enacted digital taxes on the grounds that companies are able to derive value from individuals located within their jurisdiction that is going untaxed under current taxing standards. In response to the growing number of extraterritorial taxes, which significantly diverge from traditional international taxing norms, Treasury is proposing the addition of a jurisdictional nexus requirement to the definition of what is deemed a foreign income tax. If the Proposed Regulations become final, any income taxes paid under foreign tax laws that fail to require sufficient nexus between that foreign country and the taxpayer’s activities, investment of capital or other assets that result in the income being taxed will not qualify for the FTC. As the guidance alludes to the laws of the foreign jurisdiction, a careful review of the foreign jurisdiction’s laws will likely be required in order to properly evaluate whether sufficient nexus levels have been met.
The Proposed Regulations provide that in determining sufficient nexus in a country, relevant considerations could include having operations, employees, factors of production or management in that foreign country. A tax imposed by a foreign country on a company lacking such nexus in their country will not be considered an income tax from the U.S. tax perspective and thus should not be eligible for an FTC. As it has become commonplace for companies to carry out their services digitally reaching individual users around the world, this development could have a significant impact on their overall tax burden and potentially affect how business is conducted in the digital economy altogether.
The Final Regulations provide guidance on:
- The allocation and apportionment of foreign income taxes to gross income, including for categorizing section 904(d) categories;
- The allocation and apportionment of deductions such as stewardship, legal damages, research and experimentation (R&E), and certain deductions related to life insurance companies under sections 861 to 865;
- A newly added election under section 905(c) to account for a CFC’s foreign tax redeterminations as it relates to tax years of the CFC beginning prior to Jan. 1, 2018;
- The interplay of the branch loss and dual consolidated loss recapture rules with section 904(f) and (g); and
- Applying the foreign tax credit limitation to consolidated groups.
Some of the key provisions of the Proposed Regulations include:
- Fundamental changes to the definition of what constitutes a creditable foreign income tax by requiring that the foreign income tax must have a jurisdictional nexus in order to be creditable;
- Guidance on the allocation and apportionment of foreign income taxes imposed on dispositions of stock and partnership interests as well as disregarded payments made between “taxable units;”
- The disallowance of foreign tax credits and section 245A deductions in connection with foreign income taxes attributed to dividends with which a section 245A deduction would be allowed;
- Clarification that electronically supplied services in which the value of the service provided to the end user is primarily from the service’s automation or electronic delivery (opposed to human effort), can be considered electronically supplied services for purposes of the FDII deduction; and
- An election that taxpayers can make to capitalize and amortize advertising and R&E expenditures made in connection with apportioning interest expense.
Treasury’s stance on digital taxes aligns with the department’s defense of the U.S. tax base and the proposed rules make it clear that any extra tax paid in the form of a digital services tax to a foreign country will not reduce U.S. tax receipts. Companies with potential exposure to the digital services tax should focus their attention on whether these regulations become final and consult with their tax advisors to analyze potential impacts to their global tax footprint.