Executive Summary: Taxpayers receive reassurance
Taxpayers received a much needed win on Nov. 18, 2022, when the IRS and Treasury released proposed foreign tax credit (FTC) regulations (REG-112096-22) (the 2022 Proposed Regulations) which clarify the cost recovery requirement and the application of the source-based attribution requirement to withholding tax on royalty payments. The 2022 Proposed Regulations are the government's second attempt at addressing taxpayer's complaints that the final regulations (T.D. 9959) (the 2022 Final Regulations) cause historically creditable foreign income taxes to become non-creditable. The first attempt at calming taxpayer fears came in a set of technical corrections (2022-15867 and 2022-15868) issued last summer.
To taxpayers' delight, the 2022 Proposed Regulations reassure companies that certain foreign income taxes are in fact still eligible for the U.S. FTC. Taxpayers may rely on the 2022 Proposed Regulations before they are finalized, subject to certain conditions.
Creditability of foreign taxes
In general, a taxpayer can only claim a FTC to the extent a tax is considered creditable under sections 901 and 903. Section 901 allows a credit for foreign income, war profits and excess profits taxes, whereas section 903 provides that such taxes include a tax in lieu of a generally imposed foreign income, war profits or excess profits tax. Up until the issuance of the 2022 Final Regulations, a foreign levy was an income tax if and only if (1) it was a tax, and (2) the predominant character of that tax was that of an income tax in the U.S. sense. The predominant character "test" was met if the tax (1) was likely to reach net gain in the normal circumstances in which it applied (the “net gain requirement”), and (2) was not a “soak-up” tax. To satisfy the net gain requirement, a foreign tax needed to meet three sub requirements: realization, gross receipts, and net income.
The 2022 Final Regulations revised the net gain requirement, ensuring that a foreign tax is only a creditable net income tax if the determination of the foreign tax base conforms in essential respects to the determination of taxable income under the Code. This effectively shifts the definition of a creditable tax from an income tax (i.e., a tax on income) to being a tax that is sufficiently similar to the Code. Under these new rules, a foreign tax will only satisfy the net gain requirement if the tax satisfies four sub requirements: realization, gross receipts, cost recovery (i.e., formerly the net income requirement), plus a new attribution requirement. The 2022 Final Regulations further stipulate that determining whether a foreign tax satisfies each component of the net gain requirement is generally based on the terms of the foreign tax law governing the computation of the tax base rather than empirical analysis. Lastly, the 2022 Final Regulations maintain the long-standing all-or-nothing rule. A foreign tax either is or is not a foreign income tax, in its entirety, for all persons subject to the foreign tax.
The rationale behind updating the long existing FTC rules is the recent movement by foreign governments to impose digital service taxes (DSTs). In a way, DSTs act like tariffs (i.e., a non-creditable foreign tax) against U.S. companies and essentially deviate from that of a traditional income tax. Generally, a DST consists of tax imposed on a businesses' gross receipts (i.e., a tax on gross income opposed to net income) earned on digital activity within the taxing country. Treasury's reason for disallowing a DST is that DSTs do not allow for cost recovery and the revenue is already subject to tax in the U.S. Instead of Congress simply making a judgement that DSTs are not creditable, Treasury implemented the new attribution requirement causing many previously creditable taxes to become non-creditable. The 2022 Final Regulations, however, go well beyond addressing DSTs and the 2022 Proposed Regulations aim at clarifying a few specific issues.
Changes to the cost recovery requirement
Under the 2022 Final Regulations, a tax satisfies the cost recovery requirement only if the foreign tax law permits recovery of significant costs and expenses attributable to the gross receipts included in the foreign tax base. Certain costs such as: capital expenditures, interest, rents, royalties, services and research and experimentation (R&E), are always treated as significant and thus, must be recoverable (i.e., "per se" significant costs). Costs will also be considered significant if, for all taxpayers in the aggregate to which the foreign tax applies, the cost constitutes a significant portion of the taxpayers' total costs and expenses.
While the 2022 Final Regulations recognize that, similar to the U.S., foreign countries limit the recovery of certain significant costs and expenses, and provide that foreign tax law is considered to permit the recovery of significant costs and expenses, even if recovery of certain significant costs and expenses is disallowed in whole or in part, if such disallowance is consistent with any principle underlying the disallowances required under the Code, the actual application of the cost recovery requirement was still unclear and confusing to taxpayers. Taxpayers reached out to Treasury expressing concern with a number of foreign tax laws imposing disallowances or other limitations on the recovery of costs and expenses that are not clearly matched to a principle underlying a similar disallowance under the Code, even though, in the view of these taxpayers, the foreign tax as a whole is consistent with a net income tax in the U.S. sense. Taxpayers also noted that, in some instances, it is difficult to determine the principle underlying the foreign disallowance because of a lack of information from the foreign country.
The 2022 Proposed Regulations state that the “IRS and Treasury recognize that in certain instances, the cost recovery requirement should be satisfied even if a foreign tax law contains a disallowance or other limitation on the recovery of a particular cost or expense that may not be specifically reflected under U.S. federal income tax principles.” This language suggests that complete conformity between the rules for determining the U.S. tax base and the foreign tax base is not required to satisfy the cost recovery requirement.
Further, the 2022 Proposed Regulations introduce a new safe harbor for purposes of applying the cost recovery requirement. The safe harbor rule provides that the cost recovery requirement will be met (i.e., a foreign income tax will remain creditable) in the following scenarios:
- A disallowance of a stated portion of an item, or items, of significant cost or expense does not exceed 25%;
- A limitation that caps the recovery at a stated portion of gross receipts, gross income, or a similar measure if the stated portion of such measure is not less than 15%; or
- A limitation that caps the recovery at a stated portion of taxable income (determined without regard to the item at issue) or a similar measure if the stated portion of such measure is not less than 30%.
The safe harbor does away with the need for taxpayers to point to a particular U.S. tax law principle that mirrors the foreign principle being considered and provides a more consistent and clearer set of guidelines as to what expense disallowances will not be so significant as to cause the foreign tax to fail to satisfy the cost recovery test.
Attribution requirement for royalty payments
The 2022 Final Regulations introduced an attribution requirement as a new element to the net gain requirement. The attribution requirement is intended to allow a FTC only if the country imposing the tax has sufficient nexus to the taxpayer’s activities or investment of capital that generates the income included in the tax base. For resident taxpayers, the attribution requirement will be satisfied if the foreign base is determined using arm's length principles (i.e., no destination-based criteria). There are separate rules for non-resident taxpayers. For non-resident taxpayers, the attribution requirement will be satisfied if the foreign base meets one of the following tests: activities, source or property (e.g., situs).
The source-based attribution test is met only if the gross income included in the foreign tax base is limited to income sourced to the country imposing the tax under rules that are reasonably similar to U.S. source rules. In the case of royalty income, the foreign tax law must source royalties based on the place of use, or rights to use, the intangible property (IP), consistent with how the Code sources royalty income. A withholding tax on a royalty payment is only creditable (i.e., qualifies as a "covered” withholding tax) to the extent this test is met. The 2022 Final Regulations clarified that a withholding tax on royalties which has been imposed on the basis of the residence of the payor of the royalty is not creditable, whether or not the relevant IP was in fact used within the territory of the taxing jurisdiction. Needless to say, this caused quite the uproar amongst taxpayers. Taxpayers claimed the 2022 Final Regulations created a mismatch between U.S. and foreign characterization of royalty income and the FTC rules were too restrictive on such taxes. Taxpayers have been tirelessly harping on Treasury requesting change since issuance.
The 2022 Proposed Regulations provide a new limited exception (the single-country exception), to the source-based attribution requirement where a taxpayer can substantiate that a withholding tax is imposed on royalties received in exchange for the right to use IP solely within the territory of the taxing jurisdiction. To qualify for this limited exception, a taxpayer must have proper documentation in place in the form of a written license agreement. The single-country exception applies where:
- 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 will not be treated as made pursuant to the single-country license if the taxpayer knows, or has reason to know, that the required agreement misstates the territory in which the IP 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. This agreement must be executed no later than the date on which the royalty is paid. There is a special transitory rule in place for royalties paid on or before May 17, 2023. Further, the agreement must be maintained by the taxpayer and provided to the IRS within 30 days of a request by the Commissioner, absent an exception.
Of importance, the single-country exception does not apply to services, sales of copyrighted articles, or instances in which the IP is licensed outside the foreign country imposing tax.
Treaty benefits reminder
There is still hope, as to creditability, when a foreign income tax fails the new attribution requirement. To the extent the foreign tax is an income tax under a Treaty and Treaty benefits are elected, the foreign tax is a “foreign income tax” (and generally eligible for FTC). Reg. section 1.901-2(a)(1)(iii) clarifies that a foreign tax that is treated as an income tax under a double tax article will satisfy the definition of an income tax under the regulations. Double tax articles generally apply to all taxes included within the scope of the covered tax article in the applicable treaty. U.S. treaties with a foreign taxing jurisdiction and third country treaties with a foreign taxing jurisdiction must be separately analyzed (i.e., a controlled foreign corporation (CFC) is not a U.S. resident eligible to elect the benefits of a U.S. treaty).
Did the 2022 Proposed Regulations go far enough?
While the 2022 Proposed Regulations are a much-needed win, many taxpayers will be disappointed with what was not addressed. The following topics and concerns still remain:
- IP licensed in multiple countries and the limited scope of the single-country exception for royalties;
- Cross-border payments for services and the withholding tax issue;
- How the FTC will work with countries like Brazil where the foreign income tax system does not adhere to the arm's length principle; and
- Burdensome implementation of this legislation (i.e., U.S. taxpayers must still 'understand' foreign tax law).
The 2022 Final Regulations are generally applicable to foreign income taxes paid or accrued in tax years beginning on or after Dec. 28, 2021.
Until the effective date of final regulations, taxpayers may choose to rely on the provisions addressing the cost recovery requirement and attribution requirement for royalty payments for foreign taxes paid in taxable years beginning on or after Dec. 28, 2021, and ending before the effective date of final regulations, subject to certain conditions. Generally, a taxpayer must consistently follow all proposed regulations with respect to said "portion" (i.e., cost recovery and / or royalty) for all relevant years until the effective date of the final regulations.
The provisions described in this alert are subject to change in any finally enacted regulation package. Nonetheless, taxpayers should contact their advisors now to better understand how the 2022 Proposed Regulations may affect their tax obligations.