The IRS released final regulations (T.D. 9959
) on Dec. 28 that address major aspects of the foreign tax credit regime—including tightening the rules governing the creditability of foreign taxes and potentially further restricting creditability of foreign taxes relative to the previous regulations.
The final regulations finalize some, but not all, of the provisions previously proposed in 2020 (REG-101657-20
). Most notably, the guidance re-writes the definition of “foreign income taxes,” with implications to digital services taxes and other “extraterritorial taxes.” The final regulations include numerous changes to the proposed regulations, including changes to the net gain requirement rule and replacement of the “jurisdictional nexus” rule with a similar “attribution” rule. In addition, the regulations modernize the definition of a “tax in lieu of an income tax.”
The final regulations address several other issues, including the disallowance of a credit or deduction for foreign income taxes regarding dividends eligible for a dividend received deduction, the allocation and apportionment of interest expense, and provide clarification of the foreign-derived intangible income (FDII) rules.
The effective dates of the regulations are complex. Several provisions are set to apply to tax years beginning on or after Dec. 28, 2021, while many others use applicability dates from the proposed regulations and therefore apply to prior taxable years.
Following the enactment of Tax Cuts and Jobs Act (TCJA), foreign tax credits have become critically important for multinational companies. These regulations represent a fundamental change, in some cases, to many aspects of the current foreign tax credit regime. Therefore, taxpayers should carefully assess the impact on their tax profile and consider a refreshed review of their foreign tax credit.
The U.S. foreign tax credit generally aims to shield U.S. taxpayers from being subject to double taxation on their foreign-source income. As such, the credit is generally not available to offset liabilities on U.S.-source taxable income. The foreign tax credit limitation (often referred to as the “Section 904 limitation”) is calculated separately for various categories of foreign-source income. For example, passive and general categories of income are separate income categories. The TCJA also introduced two additional separate categories of income: foreign branch and global intangible low-taxed income (GILTI). The limitation is generally determined separately with respect to each category:
The numerator of the foreign tax credit limitation computation includes foreign-source U.S. taxable income reduced by deductions allocated or apportioned to the income under Sections 861 through 865. If the allocation and apportionment of the deductions result in an overall loss in one or more categories, the separately computed losses will be allocated against net income in other categories, if any. When a net loss offsets net income of a different category, various loss recapture rules may apply.
The foreign tax credit rules have been impacted in a number of ways as a result of the TCJA. Most notably, the TCJA implemented the dividend received deduction under Section 245A, added new foreign tax credit limitation categories and repealed foreign tax credit pooling under Section 902. The addition of GILTI also dramatically increased the frequency with which taxpayers are required to compute a foreign tax credit and the complexity of such calculations.
The final regulations address an assortment of foreign tax credit-related issues, including many fundamental issues pre-dating the enactment of the TCJA. Highlights from the final regulations are summarized below.
Creditability of foreign taxes under Sections 901 and 903
Generally, Section 901 allows a credit for foreign income, war profits and excess profits taxes. Section 903 provides that such taxes include a tax in lieu of a generally imposed foreign income, war profits or excess profits tax. The pre-existing regulations, issued in 1983, set forth rules for determining when foreign taxes qualify under Sections 901 or 903. The prior final regulations treated a foreign levy as an income tax if (1) the foreign levy is a tax and (2) the predominant character of that tax is that of an income tax in the U.S. sense. A tax generally has the predominant character of an income tax if it is calculated to reach net gain in the ordinary circumstances in which the tax applies.
The final regulations make several changes to modernize and clarify the regulations to address issues that have arisen because of changes in global taxation post-1983. In particular, the final regulations modify the net gain requirement to limit the role of the predominant character analysis in determining whether a tax meets each of the components of the net gain requirement. Those components are the realization requirement, the gross receipts requirement, and the net income requirement (which under the regulations is now referred to as the “cost recovery requirement”). The final regulations also impose a fourth requirement, the “attribution requirement,” that must be satisfied for a levy to qualify as a foreign income tax (which was referred to as the “jurisdictional nexus requirement” in the proposed regulations).
While the final regulations replaced the term “jurisdictional nexus requirement” with the “attribution requirement,” the requirement substantively retains the overall general approach as provided in the 2020 proposed regulations. According to the preamble, the term “attribution requirement” more clearly reflects that the rule provides limits on the scope of gross receipts and costs that are attributable to a taxpayer's activities and thus appropriately included in the foreign tax base for purposes of applying the other components of the net gain requirement.
In order for a foreign tax or an “in lieu of tax” to qualify as an income tax, the tax must conform with established international jurisdictional taxing norms—reflected in the Code and related guidance—for allocating profit between associated enterprises, for allocating business profits and nonresidents to a taxable presence in the foreign country, and for taxing cross-border income based on source or the situs of property. This new attribution rule requires that the activity subject to the tax has a sufficient connection to the foreign country imposing the tax, largely limiting the ability to credit taxes that don’t conform to traditional taxing norms (e.g., digital services taxes and other similar taxes).
Grant Thornton Insight: In October 2021, more than 130 countries—including the U.S.—agreed to implement the Organisation for Economic Co-operation and Development’s (OECD’s) two-pillar solution on taxing the digital economy and large global companies. Pillar 1 will usher in a reallocation of taxing rights to countries brought on by an increasingly digitized global economy. If approved, foreign taxes created by Pillar 1 would likely not be creditable in the U.S. because of the attribution requirement unless further modification to the U.S. foreign tax credit rules are made or other multilateral actions are taken.
The attribution requirement provides separate rules based on whether the tax is imposed on residents or nonresidents of the jurisdiction imposing the tax. In the case of a foreign tax imposed by a foreign country on nonresident taxpayers, the regulations provided that a foreign tax satisfies the attribution requirement if it
meets one of three nexus tests:
- Income attribution based on activities (“activities-based nexus”)
- Income attribution based on source (“sourced-based nexus”)
- Attribution based on situs of property (“property-based nexus”)
To meet the activities-based nexus test, the allocation of a nonresident’s income to the nonresident’s activities in the foreign country cannot take into account, as a significant factor, the location of customers, users, or any similar destination-based criterion. 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 nonresident’s activities within the foreign country imposing the foreign tax (including the nonresident’s functions, assets, and risks located in the foreign country).
To meet the source-based nexus test, the foreign tax law sourcing rules must be reasonably similar to the sourcing rules that apply for federal income tax purposes. The final regulations made changes to ease the proposed version of the source-based nexus requirement and provide additional flexibility and clarity. Generally, sourcing principles for items of income can vary between foreign and U.S. law. To simplify and provide certainty in such instances, the final regulations provide that, in general, foreign tax law applies for purposes of determining the character of the gross income or gross receipts that arise from a transaction.
The regulations provide that gross income arising 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 based on the location of the service recipient. Thus, a withholding tax that is imposed on payments for services performed in the country imposing the tax would meet the source-based nexus requirement, but a withholding tax on fees for technical services performed outside of that country would not meet the requirement.
Additionally, the final regulations modify the separate levy rules to clarify that withholding taxes that apply different sourcing rules to subsets of a single class of gross income of nonresidents are treated as separate levies. Therefore, a withholding tax that applies a nonqualifying source rule to a subset of service income would not be creditable, but because it is treated as a separate levy, the nonqualifying source rule would not prevent a withholding tax on other services that satisfies the source-based nexus requirement from qualifying as a creditable tax.
Grant Thornton Insight: Several counties impose withholding taxes based on where the service recipient is located and not on where the services are performed. In some cases, applicable income tax treaties may eliminate such withholding taxes. However, where elimination of such taxes is not available under a treaty, such taxes may not be creditable as they would not conform to the source-based nexus rule.
Finally, the property-based nexus test provides conditions that must be satisfied for a foreign tax imposed
on the sale or disposition of property based on the “situs” of such property. The final regulations provide that the foreign taxing base may include gross receipts that are attributable to the sale or disposition of real property situated in the foreign country—or to the disposition of an interest in a corporation or other entity that is a resident of the foreign country that owns real property situated in the foreign country—under rules reasonably similar to those in Section 897 (i.e., the Foreign Investment in Real Property Tax Act (FIRPTA) rules).
In addition, a foreign tax imposed based on the situs of property may include in its base gains derived from the sale or other disposition of property forming part of the business property of a taxable presence in the foreign country, as well as gains from the disposition of an interest in a pass-through entity that has a taxable presence in the foreign country to the extent the gains are attributable to the entity’s business property in that foreign country under rules reasonably similar to those in Section 864(c).
In the case of a foreign tax imposed by a foreign country on its residents, the attribution requirement is satisfied if the foreign tax is based on certain arm’s-length principles. The base of a foreign tax imposed on residents of the foreign country imposing the foreign tax may include all of the worldwide gross receipts of a resident. However, the foreign law must provide that any allocation to or from a resident of income, gain, deduction, or loss with respect to transactions between a resident taxpayer and a related or controlled entity under the foreign country’s transfer pricing rules must follow arm’s-length principles, without taking into account as a significant factor the location of customers, users, or any other similar destination-based criterion.
Tax in lieu of income tax
Generally, taxpayers that pay taxes in lieu of an income tax to foreign countries may be eligible to claim a credit under Section 903. In order to qualify as an “in lieu of” tax, the foreign levy must meet two requirements: (i) be a tax (as determined under Treas. Reg. Sec. 1.901-2(a)(2)); and (ii) satisfy a substitution requirement. The final regulations retained this two-prong approach, but substantially modify the substitution requirement by including four additional requirements (i.e., the “generally imposed net income tax requirement,” the “non-duplication requirement,” the “close connection requirement,” and the “jurisdiction-to-tax requirement”). In order for a tax in lieu of an income tax to be creditable, these four additional requirements must be satisfied if it is not a “covered withholding tax,” or, instead, the tested tax must qualify as a “covered withholding tax.”
The final regulations addressing the substitution requirement are generally consistent with the proposed regulations, but provide additional clarifications including those related to the “close connection” and “generally imposed net income tax” requirements. For example, a foreign levy may meet the close connection requirement if the generally imposed net income tax by its terms does not apply to the excluded income, and the tested foreign tax is enacted contemporaneously with the generally imposed net income tax. In addition, the final regulations clarify that if the generally imposed net income tax, or a hypothetical new tax that is a separate levy with respect to the generally imposed net income tax, were applied to the excluded income, such generally imposed net income tax or separate levy must meet the attribution requirement but does not need to meet the other net gain requirements described above.
A tested foreign tax is a “covered withholding tax” if, based on the foreign tax law all of the following conditions are met:
Refundable tax credits
- The generally imposed net income tax requirement is satisfied
- The tested foreign tax is a withholding tax imposed on gross income of nonresidents
- A modified version of the non-duplication requirement is satisfied
- The source-based nexus requirement is satisfied
Generally, a taxpayer must both owe and remit foreign income taxes in order to be eligible for a foreign tax credit. The proposed regulations modified the existing regulations to provide explicit rules regarding the effect of foreign law tax credits in determining the amount of tax a taxpayer is considered to pay or accrue. The proposed rules provided that a tax credit allowed under foreign law is considered to reduce the amount of foreign income tax paid—regardless of whether the amount of the tax credit is refundable in cash—to the extent it exceeds the taxpayer’s liability for foreign income tax. The proposed regulations further provided an exception to this rule for credits in respect of overpayments of a different tax liability that are refundable in cash at the taxpayer’s option and applied to satisfy the taxpayer’s foreign income tax liability.
The final regulations confirm the proposed regulations providing that a foreign law tax credit that reduces a foreign income tax liability is not considered a payment of foreign tax that is eligible for a credit—including credits that are refundable in cash only to the extent they exceed tax liability and credits that are transferred from another taxpayer. However, the final regulations expand the tax overpayment exception to apply to any tax credit that is fully refundable in cash at the taxpayer’s option. The preamble states the IRS agrees that refundable tax credits may appropriately be treated as a means of paying, rather than reducing, a foreign income tax liability if the taxpayer has the option to receive in cash the full amount of the tax credit, rather than just the portion that exceeds the taxpayer’s foreign income tax liability.
This rule represents a deviation from prior administrative guidance addressing refundable foreign tax credits. The IRS has afforded taxpayers an exception—and allowed constructive payment—in several situations where the credit provided by the foreign jurisdiction is refundable when it exceeds the tax due. For example, in Technical Advice Memorandum 200146001, the IRS concluded that a research credit offered by the French government did not reduce the pool of taxes available to be claimed as a foreign tax credit at the time a dividend was distributed to a U.S. parent company. The IRS ruled that the research credit was a means of payment by the French government because taxpayers could receive the credit from the French government in either cash or as an offset against future liability.
Grant Thornton Insight: Although it is an unfavorable deviation from existing administrative guidance, the expansion of the tax overpayment exception to apply to any tax credit that is fully refundable in cash at the taxpayer’s option is a welcome change from the proposed regulations. Certain foreign jurisdictions have refundable credits that would meet this exception and may still qualify as a payment of a foreign income tax liability. However, numerous foreign research credit incentives and other incentives are only refundable to the extent the credit exceeds tax due. The fact that such incentives are no longer treated as taxes paid—but rather a reduction in the creditable taxes—could significantly impact taxpayers’ tax credits as well as their foreign effective tax rates for purposes of the GILTI high-tax exclusion and the Subpart F high-tax exception.
Allocation and apportionment of expenses under Section 861
Taxpayers use the allocation and apportionment rules to compute separate categories of foreign-source taxable income for purposes of determining the foreign tax credit limitation under Section 904. The proposed regulations provided detailed and comprehensive guidance regarding the assignment of foreign gross income—and the allocation and apportionment of the associated foreign income taxes—to the statutory and residual groupings in certain cases. Specifically, the regulations provided rules covering disregarded payments, dispositions of stock and partnership interest, and distributions by partnerships. The final regulations largely follow the proposed rules, with a few substantive modifications.
In general, the proposed regulations characterized a disregarded payment as either a payment out of the current income attributable to a taxable unit (a “reattribution payment”), a contribution to a taxable unit, or a remittance out of accumulated earnings of a taxable unit. The final regulations revise the definitions of “contribution” and “remittance” to encompass all payments outside of a reattribution payment. In addition, the final regulations make other revisions and conforming changes to the proposed rules, including a special rule related to hybrid instruments.
Rules regarding when the foreign tax credit can be claimed
The final regulations address several longstanding issues related to when the foreign tax credit can be claimed.
Specifically, the regulations provide detailed rules addressing when a foreign tax credit may be taken for both cash-method taxpayers and accrual-method taxpayers—and in the case of accrual-method taxpayers, the regulations clarify the application of the so-called “relation-back doctrine.”
The regulations also provide rules for correcting improper accruals of foreign income taxes and treat a correction as a change in method of accounting requiring a Form 3115, Application for Change in Accounting Method
The final regulations also clarify and make certain modifications to provisions related to contested taxes. Generally, a contested foreign tax credit liability accrues once the contest is resolved, and the corresponding foreign tax credit may be claimed once the liability is considered paid. The final regulations generally provide that contested foreign income taxes do not accrue and cannot be claimed as a credit in the relation-back year until the contest is resolved—even if the taxpayer remits the contested taxes to the foreign country. However, the final regulations provide an elective exception for accrual basis taxpayers to claim a “provisional credit” for the portion of the contested taxes that the taxpayer has paid, even though the contest has not been resolved. To make this election, a taxpayer must agree to an extension of the statute of limitations and comply with annual reporting requirements.
Rules addressing Section 250
The final regulations clarify the definition of “electronically supplied services” included in the FDII final regulations. The prior regulations define the term “electronically supplied service” to mean a general service (other than an advertising service) that is delivered primarily over the internet or an electronic network. The regulations could be interpreted in a manner that includes services applying some human effort or judgment (e.g., professional services that are provided through the internet). Hence, the final regulations clarify that, in order to be an electronically supplied service, the value of the service to the end-user must be derived primarily from the service’s automation or electronic delivery. The final regulations largely mirror the proposed regulations with only a minor change to clarify that the definition does not depend on whether the services are rendered synchronously or asynchronously, but rather depend on whether the services primarily involve human effort.
The final regulations also address other topics, including:
- Determination of foreign income taxes subject to disallowance under Section 245A(d)
- Impact of the repeal of Section 902 on the regulations under Section 367(b)
- Sourcing of Subpart F inclusions, GILTI inclusions and qualified electing-fund inclusions under the passive foreign investment company rules
- Revision to the CFC netting rule
- Allocation and apportionment of Section 818(f) expenses of life insurance companies
- Allocation of foreign income tax liabilities in connection with certain mid-year ownership transfers and reorganizations
- Foreign branch category rules and definition of financial services entity for purposes of Section 904
In addition, the preamble of the final regulations state that the IRS did not finalize and will continue to study the following rules:
- An election to capitalize certain expenses (such as R&E and advertising) for purposes of determining tax book value of assets when apportioning interest expense
- Rules addressing the direct allocation of interest expense incurred by certain foreign bank branches
- The definition of “financial services income.”
The final regulations’ applicability dates are complex and vary by provision. While several of the final regulations apply to tax years beginning on or after Dec. 28, 2021, there are certain provisions that apply to earlier or later tax years depending on the provision.
For example, the changes to Treas. Reg. Sec. 1.901-2, including the net gain requirement, generally apply to tax years beginning on or after Dec. 28, 2021. However, a delayed applicability date applies to foreign taxes paid to Puerto Rico by reason of Section 1035.05 of the Puerto Rico Internal Revenue Code of 2011, as amended. Under the delayed rule, the section applies to such Puerto Rican taxes paid in taxable years beginning on or after Jan. 1, 2023.
An example of the retroactive application incudes the applicability date with respect to the rules addressing the allocation and apportionment of foreign income taxes when Section 904 is the operative section under Treas. Reg. Sec. 1.861-20. These rules apply to tax years beginning after Dec. 21, 2019, and ending on or after Nov. 2, 2020.
Given the complex and varied applicability dates, taxpayers should carefully review not only which provisions are applicable to them but also the periods to which those provisions apply.
The final regulations significantly alter many aspects of the foreign tax credit landscape and will likely restrict many taxpayers’ ability to credit foreign taxes relative to the prior regulations.
Recently, several novel extraterritorial taxes, or taxes that diverge in significant respects from U.S. tax rules and traditional norms of international taxing jurisdiction, have been enacted by non-U.S. jurisdictions. The final regulations will likely prevent many of these extraterritorial taxes from being credited by taxpayers, including the global prevalence of digital services taxes. However, the regulations’ impact is likely to be far reaching, also preventing other non-traditional taxes from being credited, such as a withholding tax on fees for technical services performed outside of the taxing jurisdiction. Beyond this, certain long-standing opportunities, such as the application of the current administrative guidance as it relates to refundable credits, was significantly curtailed by these regulations.
The final regulations cover a broad range of complex tax areas beyond those described in this article. Taxpayers should carefully assess how the regulations affect their specific tax circumstances, including a fresh look at all non-traditional taxes generally claimed as a foreign tax credit, a holistic overview of the foreign tax credit profile, a refreshed look at all non-U.S. tax credit incentives, and a review of the amended allocation and apportionment rules.
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