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Key Issues Addressed by Final Foreign Tax Credit Regulations

By: Jason Carter |

On January 4, 2022, Treasury and the IRS published final regulations (2022 Final Regulations)(T.D. 9959) under the Tax Cuts and Jobs Act (TCJA)(P.L. 115-97) addressing several issues related to the foreign tax credit (FTC). This is the third set of final regulations that have been issued related to the core provisions of the US FTC regime following the TCJA.

The 2022 Final Regulations include final rules on certain of the proposed FTC regulations that were published in November 2020 (2020 Proposed Regulations)(REG-101657-20). Some provisions of the 2020 Proposed Regulations were not finalized in this new guidance, which continue to be studied by Treasury and the IRS.

This True Insight will highlight key issues addressed by the 2022 Final Regulations. The summary will cover new rules related to the creditability of foreign taxes under Sections 901 and 903, specifically focusing on the new attribution and net gain rules; timing rules for claiming FTCs; the allocation and apportionment of foreign income taxes; and the disallowance of FTCs or deductions under Section 245A.

Background

The 2022 Final Regulations include 147 pages of preamble language and 219 pages of regulatory language. They provide guidance on these issues, which are discussed in this article:

  • The definition of a creditable foreign income tax and an in-lieu income tax, including a new attribution requirement (previously the “jurisdictional nexus” requirement)
  • Timing rules for claiming a FTC
  • The allocation and apportionment of foreign income taxes
  • The disallowance of a FTC or deduction for foreign income taxes with respect to dividends eligible for a dividends-received deduction under Section 245A

Two sets of final FTC regulations were published previously by Treasury and the IRS.  See T.D. 9882 (December 2019) and T.D. 9922 (November 2020).

The 2022 Final Regulations are generally effective on March 7, 2022 (60 days after publication in Federal Register), but certain provisions are applicable to periods beginning before that date.

Sections 901 and 903: FTC Creditability

The 2020 Proposed Regulations introduced new requirements for a foreign tax to be creditable under Sections 901 and 903, including the addition of a jurisdictional nexus requirement and changes to the net gain requirement. The 2022 Final Regulations adopt the new requirements with some minor changes, despite the public opposition to the new provisions.

When first proposed, these rules were criticized as being a departure from established law and were questioned as to whether they were consistent with legislative intent, the historical concept of a foreign income tax under Section 901, and the plain language and structure of the statutory FTC rules. The new rules were intended to address novel extraterritorial taxes such as the digital services taxes (DSTs) that have been enacted or introduced by many countries in the past few years.

In the past several years, some foreign countries have been adopting or considering unilateral measures, such as DSTs, which take into account as a significant factor the location of customers, users, or other similar destination-based criteria as well as the location of persons from whom the nonresident makes purchases in the foreign country. In Treasury’s view, these types of taxes are not income taxes, and thus should not be credited for US tax purposes. In response to these types of taxes, the IRS included in the 2020 Proposed Regulations a jurisdictional nexus requirement for FTC creditability.

The Preamble addresses this criticism by stating that the new rules align with US concepts underlying the taxation of non-residents as well as the policy of ensuring that FTCs do not erode US tax on US income. Treasury determined that it was reasonable to interpret the FTC statutes as incorporating a jurisdictional nexus requirement, which was renamed the “attribution requirement” in interpreting the terms “income tax” and “tax in lieu of an income tax.”

TPC Observation:  The 2022 Final Regulations represent a major development in the US FTC regime because they fundamentally change the scope of foreign income taxes that are creditable under Sections 901 and 903.  They are expected to result in a significant reduction in the amount of FTCs that taxpayers will be able to claim. The fact that the rules limit FTCs to foreign income taxes that conform closely to US tax law will result in issues for taxpayers in some cases where creditability was clear under prior law.  Therefore, taxpayers are advised to reassess all of their foreign taxes that generate their FTCs to determine whether they will be creditable going forward under this new regulatory framework.

Effective Dates: In general, the provisions of the 2022 Final Regulations that apply to the creditability of foreign taxes, which are the amendments to Treas. Reg. §1.901-2, apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021, which is the date on which the regulations were filed with the Federal Register.

Section 901 – Creditability of FTCs

The United States taxes US persons on their worldwide income, but provides the FTC to mitigate the possibility of double taxation of foreign income.  The Code says that a US person is entitled to claim a FTC for a levy imposed on the taxpayer’s income (in addition to “in lieu of taxes,” which are discussed below) by a foreign government, and paid or accrued by the taxpayer during the tax year.

Under former Reg. §1.901-2, a foreign levy meets the definition of “income tax” if:

  • It is a tax; and
  • The predominant character of the tax is that of an income tax in the US sense.

The predominant character of a foreign tax is that of an income tax in the US sense if it meets the net gain requirement and it is not a soak-up tax (i.e., the tax liability is not dependent on the ability to credit the tax against the income tax in another country).

Attribution (Jurisdictional Nexus) Requirement

The 2020 Proposed Regulations introduced new requirements for a foreign tax to be creditable under Sections 901 and 903, including the addition of a jurisdictional nexus requirement.

In the Preamble to the 2022 Final Regulations, Treasury describes Congress’ consistent concern that foreign tax credits should not be allowed to offset US tax on income that does not have a significant connection to the foreign jurisdiction taxing such income.  The foreign tax law must require sufficient nexus between the foreign country and the taxpayer’s activities or investment of capital or other assets that give rise to the income being taxed, Treasury said. “Therefore, a tax imposed by a foreign country on income that lacks sufficient nexus to activity in that foreign country (such as operations, employees, factors of production) is not creditable,” according to the 2022 Final Regulations. Treasury officials have explained that this is a long-standing approach to defining income taxes, which determines creditability under Section 901 by evaluating whether the foreign tax, if it were to be enacted in the US, would be an income tax.

The 2022 Final Regulations revise the jurisdictional nexus requirement and rename it the “attribution requirement.” Also, it was moved and added as a condition of the net gain requirement of Reg. §1.901-2(b)(5).

Under the 2022 Final Regulations, a foreign levy is a foreign income tax only if it either:

  • Is a net income tax as defined in Reg. 1.901-1(a)(3), or
  • Is a tax in lieu of an income tax as defined in Reg. 1.901-1(b).

A treaty exception is provided (and discussed below).

TPC Observation:  Although Treasury made modifications to this requirement in response to taxpayer comments, there continues to be significant opposition to the new rules from taxpayers who argue that double taxation will result in many cases, including cases where the creditability was clear under the prior rules, but is no longer available. Tax experts and trade associations are considering a variety of actions in response to the new final rules including drafting letters to Treasury and possible litigation based on the premise that Treasury has overstepped its authority with respect to the new rules.

Under the new attribution rule, Treasury has taken the position that in order to qualify as an income tax, the foreign tax must meet the traditional realization, gross receipts, and cost recovery tests (as modified by the 2022 Final Regulations)(discussed below), and the foreign tax must be sufficiently similar to the US federal income tax under standards set forth by Treasury. The attribution rule applies differently to foreign taxes imposed on residents of the taxing jurisdiction and those imposed on nonresidents.

In the case of a foreign tax imposed on non-residents, the attribution rule requires that the gross receipts and costs attributable to each of the items of income included in the foreign tax base must satisfy one of three possible attribution tests: the activities test, the source test, or the situs test.

Under the activities test, the gross receipts and costs included in the base of the foreign tax must be attributable, under reasonable principles, to a non-resident’s activities within the foreign country imposing the tax (including the non-resident’s functions, assets, and risks located in the country). “Reasonable principles” include rules similar to those for determining effectively connected income (ECI) under Section 864(c).

However, foreign tax rules that take into account as a significant factor the mere location of customers, users, or any other similar destination-based elements, or the mere location of persons from which a non-resident makes purchases do not satisfy activities-based nexus.  Also, activities based-nexus is not satisfied in the case of rules that deem the existence of a trade or business or a permanent establishment (PE) based on the activities of another person, or that attribute gross receipts or costs to a non-resident based on the activities of another person.

Under the source test, the income included in the foreign tax base must be determined on the basis of source-of-income rules that are reasonably similar to the source-of-income rules in the Code, although they “need not conform in all respects” to the interpretation that applies for US income tax purposes. The 2022 Final Regulations include additional rules for determining if such foreign sourcing rules are reasonably similar to US rules.

The source test does state that certain foreign law source rules must mirror rules in the Code, specifically saying that a foreign law source rule for services will only be considered reasonably similar if it is based on where the services are performed. A foreign law source rule for royalties will only be considered reasonably similar if it is based on the place of use of or the right to use the intangible.  In the case of sales of property, the source test is not available, meaning that a foreign tax on non-residents can only satisfy the attribution rule under the activities test or the situs test.

Under the situs test, a foreign tax imposed on a non-resident’s gain from the sale of property that is based on the situs of the property must be attributable to gross receipts from the disposition of real property located in the foreign country, or an interest in a resident entity that owns the real property, under rules reasonably similar to the US Foreign Investment in Real Property Tax Act (FIRPTA) rules under Section 897. Gross receipts attributable to the disposition of non-real property only include gross receipts attributable to property forming part of the business property of a taxable presence in the foreign country imposing the foreign tax under rules that are reasonably similar to the Section 864(c) rules.

In the case of a foreign tax imposed on residents of the taxing jurisdiction, the attribution rule allows the foreign tax base to be computed based on worldwide income, but it requires that any allocation of income, gain, loss or deduction with respect to transactions between the resident and related persons under the foreign country’s transfer pricing rules must be determined under the arm’s length principle.  This must not take into account as a significant factor the location of customers, users or any other similar destination-based elements.

Net Gain Test

Under the prior regulations, the net gain requirement was met if a foreign tax reached the net gain of a taxpayer in the “normal circumstances” in which it applies.  The net gain requirement consists of realization, gross receipt, and cost recovery requirements, and now under the 2022 Final Regulations, the attribution requirement. The 2020 Proposed Regulations modified factors of the net gain test by providing generally that a foreign income tax satisfies those factors only if it conforms closely to US tax law.

Under the net gain test in the 2022 Final Regulations, a foreign tax is analyzed based on: (1) the events that trigger liability for tax, which is realization; (2) the revenue subject to tax, which is gross receipts; (3) whether the tax permits the recovery of significant costs or expenses attributable to those gross receipts, which is the cost recovery requirement, and (4) application of the attribution requirement.

The 2020 Proposed Regulations required that the determination of whether a foreign tax met each of these three requirements would be based on the terms of the foreign tax law governing the computation of the tax base, and that the foreign tax be closely analogous to US law with respect to each requirement. The 2022 Final Regulations generally adopt the rules in the 2020 Proposed Regulations with some minor changes.

Realization

Under prior regulations, a foreign tax generally satisfied the realization requirement if it is imposed at the same time or after an event which, under the Code, would result in the realization of income.  The 2022 Final Regulations reflect the determination by Treasury and the IRS that amounts that are included in the foreign tax base but are not a result of realization events should not prevent an otherwise-qualified foreign tax from qualifying as an income tax.  They provide that the foreign tax may still be treated as meeting the realization requirement if the portion of the foreign tax base that is the result of nonrealization events is minimal relative to the portion of the foreign tax base that is the result of realization events. This determination is made based on the application of the foreign tax to all taxpayers subject to it, rather than on a taxpayer by taxpayer basis.

Gross Receipts

Generally, a foreign tax satisfies the gross receipts requirement if it is imposed on the basis of gross receipts, determined on the basis of its predominant character.  The 2022 Final Regulations follow the 2020 Proposed Regulations rule that eliminates the prior law “alternative gross receipts test.”

The new rules, however, do state that deemed gross receipts resulting from deemed realization events or insignificant non-realization events that meet the realization requirement could also meet the gross receipts requirement if the deemed gross receipts are reasonably calculated to produce an amount that is not greater than fair market value.

The proposed rule for determining actual gross receipts is removed and clarified in an example.

Cost Recovery Rules

The 2022 Final Regulations are generally consistent with the 2020 Proposed Regulations in making some  changes to prior regulations on this issue (the “net income” requirement) and renaming it the “cost recovery requirement.”  Under the new rules, the tax base is computed by reducing gross receipts by significant costs and expenses that are attributable under reasonable principles to such gross receipts. Certain costs are deemed to be significant costs that must be recoverable in all cases including capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation.

Rules are provided for foreign law disallowances that are stricter than US tax law but still meet the cost recovery requirement. The 2022 Final Regulations eliminate some prior law rules related to testing whether a gross basis tax may meet the cost recovery requirement and the “alternative allowance rules” (with a narrow exception).

Definition of In-Lieu-of Tax

The 2022 Final Regulations under §1.903-1 incorporate the attribution requirement into the rules for Section 903 “in-lieu-of taxes” which determine creditability of certain non-income taxes. They also revise the substitution requirement by more specifically defining when a foreign tax is considered “in lieu of” a generally imposed income tax.

Under Section 903, the levy must be a tax, and it must meet the substitution requirement, which has been expanded into a 4-part test, each part of which must be satisfied. The substitution requirement includes:

  1. The foreign country that imposes the tested foreign income tax must also generally impose a separate levy that is a foreign income tax.
  2. The tested foreign tax must be “non-duplicative,” i.e., none of the gross receipts in the tax base of the tax can also be included in the tax base of the generally applicable income tax. The income that is included in the base of the tested foreign tax is “excluded income.”
  3. The generally-imposed income tax would have been imposed on the “excluded income” but for the existence of the tested foreign tax. A “close connection” must exist between the two taxes, so that the taxpayer can show that the foreign country made a “deliberate and conscious choice” to impose the tested tax in lieu of the normal income tax. This must be proven by taxpayers through specific means, such as foreign legislative history or cross-references between the two taxes.
  4. The tested tax must satisfy the attribution requirement under 1.901-2.

The 2022 Final Regulations also include special rules governing the circumstances under which a “covered withholding tax” is creditable under Section 903. In addition to being imposed on a non-resident and not being duplicative the general income tax, the withholding tax must satisfy the conditions of the attribution requirement for a source-based tax, which means that the withholding tax must be imposed on the basis of a source rule rather than on the basis that it is an outbound payment.  The source rule must be reasonably similar to the US source rule for payment of the same character.

These rules generally apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021.

TPC Observation:  The attribution requirement may render many withholding taxes on payments for services ineligible for FTCs when services are performed outside of the jurisdiction imposing the tax.  Many companies may find this limits their ability to claim FTCs in 2022 if there continues to be a reduced amount of international travel due to the COVID-19 pandemic.

Attribution Rule – Treaty Exception

Treas. Reg. §1.901-2(a)(1)(III) provides an important treaty exception in the case of foreign taxes paid or accrued by a US taxpayer.  Foreign taxes that are treated as income taxes under the relief from double taxation article of a US treaty are treated as foreign income taxes, and are creditable, if they are paid or accrued by a US citizen or resident that elects benefits under the treaty.

The attribution requirement does not apply where a tax is directly paid by a US resident and is treated as an income tax under an applicable US income tax treaty.  To confirm that the foreign tax is creditable under a treaty, it is necessary to determine whether that tax is a covered tax under the treaty.  Generally, a covered tax under a treaty is a tax that was in existence at the time the treaty was signed or a later-adopted tax that is “identical or substantially similar” to such pre-existing taxes.

Timing Rules for Claiming a FTC

The 2022 Final Regulations provide a set of rules that govern when FTCs may be claimed, which generally follow longstanding principles.  There are, however, some important changes.

Accrual basis taxpayers

For accrual basis taxpayers, accrual occurs once the liability is both fixed and determinable, i.e., both the fact of the liability has been established and the amount of the liability can be determined with reasonable accuracy.

Section 905(a) Election

Generally, a Section 905(a) election is a one-time, irrevocable election.  The election, however, can be made on an amended return only by a taxpayer that has never previously claimed a FTC.

Contested Taxes

A contested FTC liability generally accrues once the contest is resolved and a FTC may generally be claimed once the liability is considered paid.  A taxpayer, however, may elect to claim a FTC before the contest is resolved if the contested taxes:

  • Are paid to the foreign tax authority, and
  • Relate to a taxable year in which the taxpayer has claimed a FTC for foreign income taxes that accrue in such year.

Partnerships and Other Pass-through Entities

A partner that claims a FTC in a tax year may claim a FTC for its distributive share of foreign income taxes paid or accrued by the partnership, determined under the partnership’s method of accounting, during the partnership’s tax year that ends with or within the partner’s tax year.  Both accrual and cash method partners may elect to claim a provisional FTC for their share of a contested foreign income tax liability that has been paid either by the partnership or the partner.

Correction of Improper Accruals

The modified cut-off approach for correcting improperly accrued taxes requires a downward adjustment in the case of foreign income taxes that were improperly accrued and deducted or credited in a prior year and an upward adjustment in the case of foreign income taxes that had properly accrued but that had not been taken as a deduction or credit by the taxpayer.  The 2022 Final Regulations expand this approach to take into account circumstances in which a taxpayer may have both a downward and upward adjustment.

Allocation and Apportionment of Foreign Income Taxes – Partnerships & Disregarded Payments

Partnerships

The 2022 Final Regulations retain the rule in the 2020 Proposed Regulations which assigns foreign gross income arising from a partnership distribution in excess of the US capital gain amount by reference to the asset apportionment percentages of the tax book value of the partner’s distributive share of the partnership’s assets.

Disregarded Payments

The 2022 Final Regulations also include new rules related to disregarded payments providing more detail on rules that were included in the 2020 Proposed Regulations. The tax book value of assets continues to be the basis for characterizing foreign gross income included as a result of a remittance.  The definition of assets of a taxable year, however, is expanded to include the taxable unit’s pro rata share of the assets of another taxable unit in which the first taxable unit owns an interest. Also, the definitions of “contribution” and “remittance” are revised so that, together, the terms describe all payments that are not reattribution payments.

Disallowance of FTC or Deduction under Section 245A(d)

Section 245A(d) generally denies a credit or deduction for any foreign income taxes paid or accrued with respect to a dividend for which a Section 245A deduction is allowed. The 2020 Proposed Regulations provided that taxpayers could not credit or deduct foreign income taxes paid or accrued with respect to the following:

  • Dividends for which a Section 245A deduction is allowed;
  • Hybrid dividends;
  • Subpart F inclusions attributable to tiered hybrid dividends; and
  • Distributions of Section 245A(d) previously taxed earnings and profits (PTEP).

After reviewing public comments, Treasury and the IRS agreed with taxpayers that there was a lack of clarification related to some of the proposed rules, including with respect to determining the extent to which foreign income tax imposed on a US return of capital or basis amount is treated as attributable to Section 245A dividend eligible amounts.  They dropped the use of the terms “specified distributions” and “specified earnings and profits” from the 2020 Proposed Regulations.

In response to the public comments, Treasury and the IRS rewrote (but did not “re-propose”) the 2020 Proposed Regulations in this area with respect to Section 245A(d) by replacing the key terms with two new key terms (i.e., “Section 245A(d) Income” and “non-inclusion income”), adding over 20 newly defined terms, and providing two new examples. The rewritten rules do provide more clarity but they generally follow the same fundamental principles as the 2020 Proposed Regulations.

The disallowance of a FTC applies not only to foreign income taxes that are paid or accrued with respect to certain distributions and inclusions, but also to taxes paid or accrued by reason of the receipt of a foreign law distribution with respect to stock, a foreign law disposition, ownership of a reverse hybrid, a foreign law inclusion regime, or the receipt of certain disregarded payments to the extent the foreign income taxes are attributable to §245A(d) income. The disallowance also applies where a foreign corporation pays or accrues foreign income taxes that are attributable to §245A(d) income of the foreign corporation.  The taxes are not eligible to be deemed paid taxes under Section 960 in any taxable year.

The 2022 Final Regulations deny the FTC and deduction for foreign income taxes attributable to:

  • “Section 245A(d)” income of a domestic corporation, a successor of a domestic corporation, or a foreign corporation; or
  • “non-inclusion income” of a foreign corporation.

Section 245A(d) income is:

  • With respect to a domestic corporation, dividends or inclusions that are eligible for a 245A(a) deduction, a distribution of §245A(d) PTEP, and hybrid dividends and inclusions related to tiered hybrid dividends;
  • With respect to a successor of a domestic corporation, the receipt of a distribution of 245A(d) PTEP; and
  • With respect to a foreign corporation, subpart F income items that gave rise to a 245A(a) deduction, a tiered hybrid dividend, and a distribution of §245A(a) PTEP.

Non-inclusion income of a foreign corporation means items of gross income other than subpart F income, tested income, or items of income constituting post-1986 undistributed US earnings.

The allocation and apportionment rules in Treas. Reg. §1.861-20 (with some modifications) apply to determine whether foreign income taxes are “attributable to” such §245A(d) income or non-inclusion income.  The anti-avoidance rule is retained.

These rules apply retroactively to tax years of a foreign corporation that begin after December 31, 2019, and end on or after November 2, 2020.

Other Issues Addressed in the 2022 Final Regulations

The 2022 Final Regulations also finalize the 2020 Proposed Regulations on these issues:

  • Clarification of certain foreign-derived intangible income (FDII) rules
  • Noncompulsory payments
  • Sourcing Section 951, Section 951A, and Section 1293 inclusions;
  • The impact of the repeal of Section 902 on the Section 367(b) regulations;
  • The CFC netting rule;
  • Foreign branch category income;
  • Allocating and apportioning interest deductions of certain regulated utilities and Section 818(f)(1) items;
  • Allocating the liability for foreign income taxes in connection with certain mid-year transfers or reorganizations.

Issues Under Study or Previously Finalized

Treasury and the IRS did not finalize the following provisions of the 2020 Proposed Regulations, which they continue to study:

  • Proposed Regulation 1.861-9(k) related to the election to capitalize certain expenses in determining the tax book value of assets;
  • Proposed Regulation 1.861-10(g) requiring the direct allocation of interest expense incurred by certain foreign banking branches;
  • Proposed Regulation 1.904-4(e)(1)(ii) and §1.904-5(b)(2) related to the definition of financial services income and financial services entity.

Treasury and the IRS had previously finalized the transition rules in the 2020 Proposed Regulations to account for carrying back post-2017 net operating losses to pre-2018 taxable years under the CARES Act (P.L. No. 116-136). The rules were finalized in T.D. 9956.

Conclusion

The 2022 Final Regulations represent a significant development in the US FTC regime and will result in the fact that foreign taxes that were clearly creditable under prior law will no longer meet the requirements for creditability.  Taxpayers should undertake a review of taxes that were historically creditable for their businesses to see if they continue to qualify.

If you have questions about any of the information in this True Insight, please contact a member of your TPC engagement team.