The IRS released proposed regulations (REG-112096-22) on Nov. 18 that provide limited relief for unpopular final regulations issued in January. The new proposed rules soften the cost-recovery requirement for foreign taxes, offer a new exception from the source-based attribution requirements to royalty withholding taxes, and exclude disregarded sales from the definition of “reattribution asset” for purposes of allocating and apportioning foreign income taxes. The new proposed regulations were highly anticipated by taxpayers and practitioners after the final FTC regulations were heavily criticized for tightening the rules too much for determining which foreign levies are creditable foreign taxes.
The previous regulations were finalized on Jan. 4, 2022, (T.D. 9959), with correcting amendments issued in July. The rules revised the net gain requirement in an effort, according to the IRS, to better align the regulations with the Code, as well as to simplify and clarify the application of the tests. In general, the net gain requirement is satisfied only where a foreign tax simultaneously meets the realization requirement, the gross receipts requirement, the cost-recovery requirement, and the attribution requirement. The new rules for the net gain requirement were immediately unpopular and the proposed regulations now offer some relief. Some of the relief in the proposed regulations may be relied on retroactively and taxpayers should assess the impact on previous and ongoing foreign tax credit analyses.
The cost-recovery requirement
The final regulations require the gross receipts of a creditable foreign tax be offset by the recovery of significant costs and expenses attributable to those receipts under reasonable principles, and taxpayers must establish that the reason a deduction is disallowed under a foreign tax is consistent with the principles underlying disallowances in the U.S. Code.
The proposed regulations generally retain this requirement but provide additional guidance for evaluating foreign law disallowances which may not mirror U.S. tax law. Specifically, under the new guidance, the relevant foreign tax law need only permit recovery of substantially all of each item of significant cost or expense. In addition, for purposes of applying the cost-recovery requirement, the proposed regulations include safe harbors offering taxpayers additional certainty where a foreign tax law disallowance does not exceed a certain threshold or is in the form of a stated portion or cap.
Under the first safe harbor, a foreign tax is not prevented from satisfying the cost-recovery requirement if the disallowed portion of one or more items of significant cost or expense does not exceed 25%. The second safe harbor also permits the foreign tax law to cap deductions of significant costs and expenses described in proposed Treas. Reg. Sec. 1.901-2(b)(4)(i)(B)(2) so long as the cap, based solely on the terms of the foreign tax law, is not less than 15% of gross receipts, gross income or a similar measure, or is not less than 30% of taxable income or an amount similar to taxable income. Ultimately, if the foreign law disallowance does not meet the safe harbor or otherwise permit recovery of substantially all of each item of significant cost or expense, the principles-based exception would be relevant for determining whether the foreign tax could satisfy the cost-recovery requirement.
Grant Thornton Insight
The proposed regulations include an example that fully disallows all deductions relating to stock-based compensation. However, the foreign income tax continues to satisfy the cost-recovery requirement due to the underlying policy rationale that is similar to Sections 162(m) and 280G, influencing the type of compensation in the labor market. Several countries fully disallow certain deductions and under the new guidance, and these changes offer more clarity surrounding what may be a permissible foreign law disallowance based on U.S. tax principles.
Attribution requirement for royalty payments
The proposed regulations provide a limited exception to the source-based attribution requirement in the final regulations. The exception allows taxpayers to substantiate that a withholding tax is imposed on royalties received in exchange for the right to use intangible property solely within the territory of a taxing jurisdiction.
The final regulations had added an attribution requirement in Treas. Reg. Sec. 1.901-2(b)(5) as an element of the “net gain requirement.” Under the attribution requirement, the base of a foreign levy imposed on non-residents must satisfy either the activities-based attribution test, the source-based attribution test, or the property-based attribution test. The source-based attribution test requires foreign tax law to source income under rules reasonable similar to the U.S. in order for the levy to qualify. For royalty income, that meant foreign law must source royalties for intangible property based on place of use, or the right to use, in order to be consistent with U.S. law such that the foreign taxes would qualify as creditable under the source-based attribution test. This strict adherence policy was challenging because often the foreign law would arrive at an acceptable answer on royalty source, but would not get there in the manner required by the final regulations.
A new limited exception proposed in Treas. Reg. Sec. 1.903-1(c)(2)(iii) provides that a tested foreign tax satisfies the source-based attribution requirement if the tax meets either the source-based attribution requirement in current Treas. Reg. Sec. 1.901-2(b)(5)(i)(B) or the exception in proposed Treas. Reg. Sec. 1.903-1(c)(2)(iii)(B) (the “single-country exception.”)
The single-country exception applies if the income subject to the tested foreign tax is characterized as gross royalty income and the payment giving rise to such income is made pursuant to a single-country license.
The proposed regulations would also modify the separate levy rule in Treas. Reg. Sec. 1.901-2(d)(1)(iii) for withholding taxes imposed on nonresidents. In essence, the proposed regulations provide that a withholding tax imposed on a royalty payment made to a nonresident pursuant to a single-country license is treated as a separate levy from a withholding tax that is imposed on other royalty payments made to such nonresident and from any other withholding taxes imposed on other nonresidents.
Grant Thornton Insight
To meet the attribution requirement under the proposed regulations, taxpayers generally must have a license agreement in place that meets such requirements at the time a royalty is paid. The proposed regulations provide a transition rule for royalties paid on or before May 17, 2023 (including having the requisite agreement in place by such time).
Definition of ‘reattribution asset’
The reattribution asset rule in the final regulations under Treas. Reg. Sec. 1.861-20(d)(3)(v)(C)(1)(ii) requires that a reattribution of income from one taxable unit (i.e., the “payor taxable unit”) to another taxable unit (i.e., the “recipient taxable unit”) result in a reattribution of the tax book value of the assets from the payor taxable unit that generated the reattributed income (“reattribution assets”) to the recipient taxable unit.
In the proposed regulations, the IRS concludes that the reattribution asset rule is not needed for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales—and particularly with respect to disregarded sales of inventory property. Accordingly, proposed Treas. Reg. Sec. 1.861-20(d)(3)(v)(E)(6) would retain the general definition of reattribution asset but exclude any portion of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable unit.
The IRS requests comments on whether similar revisions should be made to the reattribution asset rule in situations other than disregarded property sales. The IRS further requests comments on other issues related to the allocation and apportionment of foreign income taxes to disregarded payments, which may be considered in future guidance projects.
In general, the new regulations are proposed to apply to taxable years ending on or after the date on which the regulations are filed at the Federal Register. However, once the regulations become final, taxpayers may choose, subject to certain exceptions, to apply some—or all—of the final regulations to earlier taxable years.
Under certain conditions, a taxpayer may rely on all or part of the proposed regulations until the effective date of the finalized proposed regulations. A taxpayer may choose to rely on the following provisions, if the taxpayer and its related parties consistently follow all proposed regulations with respect to that portion for all relevant years until the effective date of the final regulations adopting the rules:
- The reattribution asset rule: For taxable years that begin after Dec. 31, 2019, and end before the effective date of final regulations adopting these rules
- Cost-recovery requirement: For foreign taxes paid in taxable years beginning on or after Dec. 28, 2021, and ending before the effective date of final regulations adopting these rules
- Attribution requirement for royalty payments: For foreign taxes paid in taxable years beginning on or after Dec. 28, 2021, and ending before the effective date of final regulations adopting these rules.
The proposed regulations attempt to answer concerns raised by taxpayers and are aimed at providing some level of clarity as to which levies are creditable and which are not. The previous final regulations proved difficult to interpret and left taxpayers with uncertainty when considering creditability of foreign taxes. These regulations provide taxpayers with the ability to achieve certainty in selected areas by incorporating safe harbors. There is also the relaxed treatment of royalties arising in single country jurisdictions. Taxpayers should carefully assess how the proposed regulations may impact their previous and ongoing foreign tax credit analyses.
For more information, contact:
David E. Sites
National Managing Partner, International Tax Services Practice Leader
David leads the firm's International Tax practice, which focuses on global tax planning, cross border merger and acquisition structuring, and working with global organizations in a variety of other international tax areas.
Washington DC, Washington DC
- Technology and telecommunications
- Retail and consumer products
- International tax
Partner, Washington National Tax Office
Washington DC, Washington DC
- Technology and telecommunications
- Private equity
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