June 9, 2022

The Final Foreign Tax Credit Regulations: Is the Density a Feature or a Bug?

By Adnan Islam, Partner, Tax & Business Services

The Final Foreign Tax Credit Regulations: Is the Density a Feature or a Bug? International Tax

New foreign tax credit (“FTC”) regulations released in January 2022 have made it more difficult to obtain a “dollar-for-dollar tax credit” for foreign income taxes paid by US taxpayers with foreign business operations. In addition to the existing limitations and restrictions for claiming the elective foreign tax credit, there is now additional qualitative and technical analysis required to determine foreign tax creditability.

This is the third set of foreign tax credit regulations released since the 2017 Tax Cuts and Jobs Act (“TCJA”). Despite public commentary and opposition, the regulations are broad, extremely complex, and difficult to interpret. A primary effect of these regulations is that they significantly changed and limited the creditability of existing and new foreign income taxes. Taxpayers that have paid or accrued, or that will pay or accrue, foreign income taxes and certain withholding taxes (including from/by India, Australia, Brazil, and UK) should carefully review future creditability for FTC purposes.

Final FTC Regulations Summary

The new rules will limit foreign tax credits for foreign taxes that were clearly creditable under prior law and will raise practical and interpretive issues for taxpayers in typical fact patterns. The rules limit foreign tax credits to foreign income taxes that conform closely to U.S. tax law, including with respect to the application of the arm’s length principle, the allowance of deductions, and the sourcing of income earned by non-residents.

The regulations require sufficient nexus on the basis of U.S. tax law principles for taxing non-residents and allocating income to residents, and modify elements of the long-standing net gain test, generally providing that a foreign income tax satisfies those elements only if it conforms closely to U.S. tax law.

Jurisdictional Nexus & Net Gain Test

The jurisdictional nexus requirements are within the net gain test, providing in general that a foreign tax meets the net gain test only if the jurisdictional basis for its imposition conforms to the nexus rules that govern U.S. taxation in analogous circumstances.

Under the net gain test, the amount of gross receipts and costs that are included in the base of the foreign tax on a non-resident must meet one of the “attribution requirements,” which generally match the jurisdictional nexus requirements: (1) income attribution based on activities; (2) income attribution based on source; and, (3) income attribution based on situs of property. In the case of a foreign tax imposed by a foreign country on its residents, the final regulations provide that, (4) to meet the net gain requirement, any allocation of income or deduction between a resident taxpayer and an affiliate must follow arm’s length principles (transfer pricing). A tax can qualify as a creditable tax in lieu of an income tax only if the tax is in substitution for an income tax that would meet the attribution requirements, with specific rules applicable to withholding taxes.

Foreign Withholding Taxes

The final regulations contain special rules governing the circumstances under which a “covered withholding tax” is creditable under Section 903. In addition to being imposed on a nonresident and not overlapping in scope with the general income tax, the withholding tax must satisfy the conditions of the Attribution Requirement for a source-based tax. Meaning, the withholding tax must be imposed on the basis of a source rule rather than on the basis that it is an outbound payment (i.e., from resident to nonresident). The source rule must also be “reasonably similar” to the US source rule for a payment of the same character, as such character is determined under foreign law.

Examples of Potentially Non-Creditable Foreign Taxes

Many common foreign withholding taxes may no longer be eligible for an FTC. Foreign taxes, both new/creative (e.g., DST) and old/standard that may potentially be affected by these final regulations, include:

  • Royalty withholding taxes: For a withholding tax on what foreign law regards as a royalty payment (other than a payment for what US law regards as a sale of a copyrighted article) to satisfy the Attribution Requirement, withholding must be limited to royalties for the use or exploitation of IP in that foreign country. This requirement seems to exclude the wide variety of royalty withholding taxes that countries impose, based on a residence principle, on any outbound payment.
    • A pair of examples in the regulations clarify Treasury’s intent for broad application of the Attribution Requirement in the case of royalty withholding taxes. The examples show that a withholding tax on a royalty paid for the use of IP does not employ a source rule reasonably similar to US source rules, and would not meet the Attribution Requirement, in a case where the country requires withholding on all royalties paid by a resident to a nonresident.
    • The final regulations require only that a foreign source rule be “reasonably similar” to US source rules—and because the location of IP use is not always clear under US law (particularly in the case of patents or manufacturing IP)—there should be some leeway for foreign law to employ different principles to determine the location where IP is used and still satisfy the “reasonably similar” requirement.
  • Service payment withholding taxes: Like royalty withholding taxes, withholding taxes imposed on service payments—including commonly used withholding taxes on fees for technical services—may not satisfy the Attribution Requirement. If imposed on a source basis, such withholding taxes would need to apply only to payments for services performed in-country and not based on the location of the service recipient. If any outbound service payment (for services of a specific kind, like technical services) would be subject to withholding based on a residence principle, the withholding tax may not satisfy the Attribution Requirement regardless of whether the nonresident performs services in-country (e.g., not based on actual facts or client or taxpayer specific). This treatment of service payment withholding taxes reverses the result under the prior regulations and Section 903.
  • Capital gains taxes: Taxes imposed by a country on a nonresident’s sale of shares in a company organized in that country, or on the sale of shares in an upper tier holding company directly or indirectly owning that company, may not satisfy the Attribution Requirement. To do so, any such capital gains tax would generally need to be imposed only in situations FIRPTA would tax a nonresident on sale of shares of a real estate holding company.
  • Taxes on sales of copyrighted articles: A tax imposed by a country on the sale of a copyrighted article (g., software, whether or not digitally delivered) by a nonresident may not satisfy the Attribution Requirement if—as is the case in certain jurisdictions—the foreign country imposes the tax without regard to whether the nonresident has activities or a physical presence in the country.
  • Digital services taxes (“DST”): The Treasury considered both possibilities in the final regulations and included examples illustrating how various flavors of a DST would fail to satisfy the Attribution Requirement because the hypothetical tax does not satisfy the requirements for attributing gross income based on activities, source or the situs or property, as applicable.
  • Diverted profits taxes (“DPT”): DPTs, such as those adopted by the United Kingdom and Australia, may fail the Attribution Requirement. DPTs apply in different ways to residents and nonresidents of the levying country. A DPT imposed on a resident of the country may fail the requirement that transactions with related parties are priced in a manner consistent with the arm’s length principle. A DPT imposed on a nonresident may fail the requirement that any activities-based principle for attribution of gross receipts be based on the nonresident’s activities within the foreign country.

Non-compulsory Payments

The final regulations kept prior provisions pertaining to non-compulsory payments (i.e., non-obligatory foreign income tax). For example, an amount remitted to a foreign country (a “foreign payment”) is not a compulsory payment, and thus is not an amount of foreign income tax paid, to the extent that the foreign payment exceeds the amount of liability for foreign income tax under the foreign tax law. In short, for a foreign payment to be creditable, a taxpayer (1) must apply a reasonable interpretation and application of the foreign tax law to reduce its expected foreign income and foreign income tax liability, and (2) seek and implement all effective and practical solutions (e.g., applicable tax treaties). What constitutes reasonable interpretation and application of foreign tax law, as well as practical remedies and taxpayer required actions (for foreign tax mitigation) are also provided within the final regulations.

Effective Date

These regulations became effective March 7, 2022. They contain provisions relating to the foreign tax credit, including the disallowance of a credit or deduction for foreign income taxes with respect to dividends eligible for a dividends-received deduction; the allocation and apportionment of interest expense, foreign income tax expense, and certain deductions of life insurance companies; the definition of a foreign income tax and a tax in lieu of an income tax; the definition of foreign branch category income; and the time at which foreign taxes accrue and can be claimed as a credit. They also include final regulations clarifying rules relating to foreign-derived intangible income (FDII). The final regulations affect taxpayers that claim credits or deductions for foreign income taxes, or that claim a deduction for FDII.

Count on Marcum

Foreign tax credit rules are extraordinarily complex, and these regulations are final and effective. A thorough understanding of the U.S. source of income rules, the foreign tax credit rules, and their interplay pursuant to the new regulations will be necessary to determine creditability of several existing and new foreign taxes for FTC purposes. Please contact your Marcum advisor and/or Marcum’s International Tax Services group with any questions and for guidance on the new 2022 FTC regulations.