Earlier this year, new final foreign tax credit (FTC) regulations were published in the Federal Register.[1] These regulations, which are effective beginning with the 2022 tax year, may cause many previously creditable foreign income taxes to become non-creditable for US purposes. These changes may have wide-reaching impacts on FTC calculations and qualification for the GILTI and Subpart F high-tax exceptions. Specific foreign taxes which may no longer be creditable include:
- Withholding taxes (“WHT”) on services, royalties, etc., where the characterization or sourcing of the income under foreign law differs from US law
- Income taxes imposed by jurisdictions which do not follow Sec. 482/OECD arm’s-length transfer pricing principles (e.g., Brazil)
- Income taxes which disallow recovery of significant expenses (e.g., German trade tax, Italian IRAP)
- Some foreign taxes offset by refundable credits (i.e., R&D credits)
- Taxes based on location of customers or other destination-based criterion (i.e., “digital” taxes)
Taxes which are not creditable foreign income taxes may still be deductible for E&P/taxable income purposes.
In this blog, we examine the changes to the requirements that a foreign tax must satisfy to be claimed as a credit contained in the regulations to Sec. 901 and 903.
Many aspects of the final FTC regulations, however, remain unclear. We recommend that tax departments proactively reach out to their auditors to agree on an approach for Q1 provision and other next steps.
Foreign Tax Credits: Background
In order for a foreign tax to be creditable for US tax purposes, the foreign tax must be an income tax in the US sense.[2] The new final FTC regulations substantially revise the requirements which must be met for a tax to be considered an income tax.
The most significant changes made by the final FTC regulations include a new attribution requirement and tightening of the cost recovery requirement.
Attribution Requirement
At a very high level, the attribution requirement requires that the amount of gross receipts and costs that are included in the base of the foreign tax are determined under principles reasonably similar to US tax law.[3] This issue will be most commonly encountered in the case of WHT (i.e. Sec. 903 tax in lieu of income tax):[4]
- WHT on income which the foreign country sources differently from the US
- WHT on income which the foreign country characterizes differently from the US (e.g., service income vs. royalties)
The regulations do provide that the foreign tax law application of sourcing rules need not conform in all respects to the application of those sourcing rules for Federal income tax purposes. However, the following specific rules must be applied:
- Services — Under the foreign tax law, gross income from services must be sourced based on where the services are performed, as determined under reasonable principles (which do not include determining the place of performance of the services based on the location of the service recipient).
- Royalties — A foreign tax on gross income from royalties must be sourced based on the place of use of, or the right to use, the intangible property.[5]
- 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 on the basis of the nonresident’s activities within the foreign country, and not on the basis of source. In the case of sales of copyrighted articles (as determined under rules similar to § 1.861-18), 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.[6]
The attribution requirement may also disqualify income taxes imposed by jurisdictions which do not apply arm’s-length transfer pricing principles.[7] Note that, because an “in lieu of” tax must be a substitute for an otherwise creditable net income tax,[8] it is possible that WHT imposed by such a jurisdiction may also not be creditable.
Cost Recovery Requirement
Under the cost recovery requirement, the foreign tax law must allow for recovery of significant expenses, specifically including capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation.[9] 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 the principles underlying the disallowances required under the IRC, including disallowances intended to limit base erosion or profit shifting. For example, a foreign tax is considered to permit recovery of significant costs and expenses if the foreign tax law limits interest deductions based on principles similar to those underlying Sec. 163(j), disallows interest and royalty deductions in connection with hybrid transactions based on principles similar to those underlying section 267A, disallows deductions attributable to gross receipts that in whole or in part are excluded, exempt or eliminated from taxable income, or disallows certain expenses based on public policy considerations similar to those disallowances contained in Sec. 162.[10]
Foreign taxes such as the German trade tax or Italian IRAP which disallow significant expenses may therefore not be creditable. At this early stage, and in absence of further clarification from Treasury, there is significant uncertainty around what exact disallowances may cause a foreign tax to fail the cost recovery requirement.
US income tax treaties may provide some relief in certain cases. This should also be discussed with auditors, since whether a treaty may allow a tax to be creditable can depend on the particular facts.
Actions for Q1 Provision
The changes to the requirements for a foreign tax to be creditable must be reflected in the Q1 2022 tax provision. For most taxpayers, this will include evaluating whether current foreign income taxes and WHT are creditable under the new final regulations and assessing realizability of DTAs on FTC carryforwards.
Given the significant uncertainty around the application of the new final FTC regulations at this early stage, we encourage taxpayers to proactively reach out to their auditors to discuss the approach for estimating the impact of the new regulations for Q1 and to put a roadmap in place for continuing to refine this estimate throughout the year.
In general, the first step will be to gather the population of foreign income taxes and WHT to identify key jurisdictions. The creditability of the income taxes in each jurisdiction (and WHT on each item of income) must then be evaluated to determine whether the foreign tax conforms to the requirements in the new final FTC regulations. Finally, the impact on the taxpayer’s foreign income and FTC position can be modeled.
Note that qualification of a foreign tax as an income tax can be important even for taxpayers who are not electing to take FTCs:
- In determining whether GILTI and Subpart F high-tax exceptions are applicable
- For Sec. 163(j) purposes, in determining the ATI of a CFC (no deduction is taken into account for any foreign income tax, as defined in Reg. § 1.960-1(b)).[11]
Taxes which are not creditable foreign income taxes may still be deductible for purposes of determining a CFC’s E&P and taxable income, just as other foreign, non-income taxes are generally deductible.
Taxpayers may also begin to consider planning opportunities in response to the new FTC final regulations. Once the impact on a taxpayer’s FTC position is better understood, there may be opportunities (via check-the-box elections or other relatively simple legal entity restructurings) to convert GILTI basket tested income to general basket Subpart F and/or foreign branch income (or vice versa) in order to better utilize the available FTCs and any FTC carryforwards.
Given the short notice between issuance of the new FTC final regulations and taxpayers’ need to apply them for Q1 provision, we again encourage taxpayers to proactively reach out to their auditors and agree on an approach to estimate the impact of the new FTC final regulations for Q1.
To learn more about GTM’s International Tax Services or to speak with someone who can guide you through the process, contact us.
[1] T.D. 9959, 87 FR 276-376 (Jan. 4, 2022).
[2] Reg. § 1.901-2(a)(2)(i).
[3] Reg. § 1.901-2(b)(5).
[4] Reg. § 1.903-1(c)(2)(iii) applies the source-based attribution requirement to “in lieu of” taxes.
[5] See Sec. 861(a)(4) and Sec. 862(a)(4).
[6] Reg. §1.901-2(b)(5)(i)(B)(1)–(3).
[7] Reg. § 1.901-2(b)(5)(ii).
[8] Reg. §1.903-1(c).
[9] Reg. § 1.901-2(b)(4)(i)(C)(1).
[10] Id.
[11] Reg. § 1.163(j)-7(g)(3).
