Foreign Tax Credits – A Revisit
Vikita Shah, EA, International Tax Manager
Earlier this year, in January 2022, the US Treasury released the third set of final regulations on foreign tax credits since the enactment of the Tax Cuts and Jobs Act which was signed into law on December 22, 2017. These regulations make significant changes to the requirements for a foreign tax to be creditable. One of the main changes is the “introduction of a new attribution requirement” to the tests which a foreign income tax must satisfy to be creditable under IRC Section 901.
In recent years, many foreign jurisdictions have disregarded international taxing norms in an effort to claim additional tax revenue. This has led to the adoption of novel “extraterritorial taxes” (e.g., digital services tax, diverted profits tax, and equalization levies) which are assessed using factors such as customer base and destination. These taxes diverge in significant respects from U.S. tax rules and traditional international taxation. The final regulations are in part a response to these new taxes.
Under the prior Section 901 regulations, a foreign levy was treated as an income tax and was creditable against US tax liability if 1) it was a tax, and 2) it had the predominant character of an income tax in the U.S. sense. The “predominant character “qualification was met if the levy reached “net gain” status. The levy could achieve this status by fulfilling a realization requirement, a gross receipts requirement, and a net income requirement.
The final regulations modified each of these three requirements, in some cases making the tests to meet these requirements more restrictive. The regulations also added the above-mentioned attribution requirement as one of the requirements needed to reach “net gain”. This requirement is one of the most significant changes in the final regulations and it will impact the creditability of several foreign taxes.
To meet the attribution requirement, a non-resident of a foreign country is required to satisfy one of three tests:
1) Attribution based on activities – The gross receipts and costs that are included in the base of the foreign tax are limited to gross receipts and costs that are attributable, under reasonable principles, to the non-resident’s activities within the foreign country imposing the tax. Attribution of gross receipts, under reasonable principles includes rules similar to those for determining effectively connected income under section 864(c).
2) Attribution based on source – The amount of gross income or gross receipts that are included in the base of the foreign tax is limited to gross income arising from sources within the foreign country that imposes the tax, and the sourcing rules of the foreign tax law are reasonably similar to the sourcing rules that apply under the IRC. The following rules apply for purposes of determining whether the sourcing rules of the foreign tax law are reasonably similar to the sourcing rules that apply under the IRC.
- Services – Gross income from services must be sourced based on where the services are performed, as determined under reasonable principles, not in the location of the recipient of the services.
- Royalties – Gross income from royalties must be sourced based on the place of use, or the right to use, the intangible property.
- Sales of property – Gross income arising from gross receipts from sales or other dispositions of property (including copyrighted articles sold through an electronic medium) must be included in the foreign tax base using the activity attribution rules or the situs of property attribution rules. In the case of sales of copyrighted articles, a foreign tax satisfies the attribution requirement only if the transaction is treated as a sale of tangible property and not as a license of intangible property.
3) Attribution based on situs of property – A foreign tax may include in its base, gross receipts that are attributable to the gain from the sale or disposition of real property situated in the foreign country, or to the sale or disposition of an interest in a corporation or other entity that owns real property and is a resident of the foreign country, under rules reasonably similar to those in IRC Section 897 [i.e., the Foreign Investment in Real Property Tax Act (FIRPTA) rules]. Gain from the disposition of property (other than real property) which is part of a business having a taxable presence in a foreign country is included in the foreign tax base under rules similar to those contained in IRC Section 864 (effectively-connected income).
The final regulations clarify that a foreign tax that is treated as an income tax under an applicable US income tax treaty will qualify for a foreign tax credit if it is paid by the U.S. citizens and residents that elect to claim benefits under that treaty.
The provisions contained in the final regulations which deal with the creditability of foreign taxes apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021, with a deferred applicable date with respect to certain taxes paid to Puerto Rico.
For foreign taxes imposed on residents of foreign countries, the final regulations provide that the foreign tax base would include the worldwide gross receipts of the resident. However, any allocation of income, gain, deduction or loss resulting from the resident’s transactions with affiliates is determined under the country’s transfer pricing rules following arm’s length principles., without taking into account as a significant factor the location of customers, users, or any other similar destination-based criterion.
The final regulations are complex and cover a broad range of topics related to the foreign tax credit regime. This article focused on one aspect – the attribution requirement. Other topics addressed in the regulations include the determination of foreign income taxes subject to the credit and deduction disallowance provisions of section 245A(d), the allocation and apportionment of interest expense, foreign income tax expense, a revision to the controlled foreign corporation (“CFC”) netting rule and the timing rules for claiming a foreign tax credit for both accrual and cash basis taxpayers.
For a detailed discussion of areas that may impact you or your business, please contact one of our shareholders at Rubino.