The Treasury's first attempt at addressing taxpayer concerns raised about the 2021 final foreign tax credit (FTC) regulations (T.D. 9959) (the Final Regulations), published in the Federal Register on Jan. 4, 2022, came to fruition on July 27, 2022, when Treasury published a set of technical corrections (2022-15867 and 2022-15868). In general, these corrections attempt to address taxpayer concerns that the cost recovery provisions of the final regulations will make many foreign income taxes non-creditable.
Under the Final Regulations, a foreign tax is generally creditable for U.S. tax purposes only if it satisfies a "net gain requirement," which includes a four-prong all or nothing test, consisting of: realization, gross receipts, cost recovery, and attribution.
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, 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. Under these stringent requirements, taxpayers were concerned that a disallowance of a deduction for all or even just a small portion of these "per se" significant costs would trigger an immediate failure of the cost recovery requirement unless this foreign law disallowance was consistent with corresponding U.S. tax principles. In other words, taxpayers became concerned that if a foreign country's tax treatment of a cost did not match the U.S. tax treatment of a cost recovery item, the foreign tax would fail to qualify as a creditable tax.
The technical corrections provide some relief to taxpayers by amending Reg. section 1.902-2 and removing the word "significant" in describing the type of capital expenditures subject to these rules. The Preamble to these corrections also indicates that foreign tax law is considered to permit recovery of significant costs and expenses even if recovery of all or a portion of certain costs or expenses is disallowed, if such disallowance is consistent with any principle underlying disallowances required under the Internal Revenue Code, including the principles of limiting base erosion or profit shifting and public policy concerns. The corrections go on to provide examples (not an all-inclusive list) in which a foreign tax is considered to permit recovery of significant costs and expenses if the foreign tax law:
- Limits interest deductions based on a measure of taxable income (determined either before or after depreciation and amortization),
- Disallows deductions in connection with hybrid transactions,
- Disallows deductions attributable to gross receipts that in whole or in part are excluded, exempt or eliminated from taxable income, or
- Disallows certain deductions based on public policy considerations similar to those underlying the disallowances contained in section 162.
These corrections are seemingly in line with Treasury's previous public commentary. As Treasury officials have long maintained that foreign and U.S. law do not have to be precisely the same to meet the cost recovery requirement.
While the technical corrections may seem like a warm welcome to taxpayers, there is still much uncertainty when it comes to practice and application. The final regulations and corrections still place the burden of analysis on the taxpayer. Not only will U.S. taxpayers be tasked with understanding the intricacies of U.S. tax law, but they will need to focus on foreign country tax law and begin to draw correlations between foreign and U.S. tax law in ways they never had to do before.
Global Intangible Low-Taxed Income (GILTI) & high-tax exclusion
The technical corrections have officially resolved a potential oversight of the 2021 final regulations. The technical corrections amend the GILTI high-tax exclusion regulations to now refer to "eligible current year taxes" (as defined in Reg. section 1.960-1(b)(5)) as opposed "current year taxes" (as defined in Reg. section 1.960-1(b)(4)) when determining foreign income taxes paid or accrued with respect to a tentative tested income item. This seemingly small revision ensures that when computing the effective tax rate for purposes of the GILTI high-tax exclusion, only creditable foreign income taxes, not those for which an FTC is unavailable, are taken into consideration. Eligible current year taxes exclude taxes for which a credit is disallowed at the level of a controlled foreign corporation (e.g., under sections 245A(d) or 901(j), (k), (l), or (m). These technical changes may limit the amount of foreign taxes that a taxpayer may claim as a credit, so taxpayers should assess their potential impact.
Now that technical corrections have been issued, Treasury may propose a "safe harbor" for withholding taxes on royalties in order to address taxpayer complaints that the FTC rules are too restrictive on such taxes. Under the new attribution framework, these once creditable taxes will likely be rendered ineligible for credit whenever the characterization or sourcing of the income under foreign law differs from U.S. law, absent an in-force income tax treaty.