Initial Changes to the Foreign Tax Credit
When final regulations were issued in late 2021, the regulations limited “creditability” to foreign income taxes that largely conform to U.S. tax laws, including tax related to income sourcing, allowable deductions and application of the arm’s length principle. The good news: tax treaties preserve creditability, provided the treaty has certain provisions. The proposed regulations provide some limited relief in non-treaty situations as long as royalty agreements are modified by May 17, 2023.
Taxes Levied on Nonresidents
In order for foreign tax related to activities to be creditable, gross receipts and costs must be attributable to the nonresident’s activities in the foreign country, including its functions, assets and risks. The tax may not be based merely on the location of customers, users or similar destination-based criteria.
For a foreign tax based on income arising from sources within the foreign country, the regulations require foreign tax laws be reasonably akin to U.S. sourcing rules. Income from services must be taxed where the services are performed, not where the recipient is located. Royalty income must be sourced to the place of use or right of use, which can be especially problematic.
Foreign taxes based on “situs” (location of property) must be reasonably similar to U.S. rules and may be levied only on:
- Gains on the disposition of real property located in the foreign country or of an interest in an entity that resides in the foreign country and owns real property there.
- Dispositions of business property or of an interest in a partnership or other pass-through entity that has a taxable presence in the foreign country to the extent gains are attributable to the entity’s business property in the foreign country.
For residents of a foreign country imposing destination-based taxes, the regulations require that any allocation made under the foreign country’s transfer pricing rules must be determined under arm’s length principles. This must be done without significantly considering the location of customers, users or similar destination-based criteria. Transfer pricing rules that are consistent with the arm’s length standard under Internal Revenue Code Section 482, or with the Organization for Economic Cooperation and Development’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, will satisfy this requirement.
However, it is irrelevant whether taxpayers apply arm’s length principles in their transactions or even engage in related-party transactions. Creditability is denied where the foreign country’s transfer pricing rules, as generally applicable to all taxpayers, do not adopt arm’s length principles or where those rules use destination-based criteria. For example, Brazil is a country often cited as having this problem, where taxpayers may not be able to claim a credit for taxes paid to that country.
The regulations provide a treaty coordination rule. It clarifies a foreign levy that is treated as an income tax under an income tax treaty between the United States and the foreign country imposing the tax is a foreign income tax if paid by a U.S. citizen or resident (as determined under the treaty) that elects benefits under the treaty.
Effectively, where a foreign levy does not meet the requirements under the regulations, it might still be creditable if:
- An income tax treaty is in effect between the United States and the foreign country.
- The foreign levy is an income tax under the relief from double taxation article of the treaty (in other words, a tax referred to in the treaty’s taxes covered article).
- The tax is paid by a U.S. citizen or resident who is eligible for a credit against U.S. income taxes under the relief from double taxation article and who elects benefits under the treaty.
To elect benefits under a tax treaty, a taxpayer must generally disclose the treaty-based return position, pursuant to Section 6114. This is done by attaching Form 8833 to the taxpayer’s return.
A word of caution when it comes to tax treaties – a tax treaty between the United States and a foreign country does not provide relief if the foreign levy is paid by a controlled foreign corporation (CFC) of a U.S. parent company, rather than paid directly by the U.S. parent company. This is because the CFC is not a U.S. resident eligible to elect benefits under the tax treaty.
Proposed Non-Treaty Relief
The proposed regulations would provide relief to the source-based attribution provided by a royalty agreement:
- Characterize the payment as a royalty, and
- Either limit the territory of the license to the foreign country imposing the withholding tax (“single -country license”) or specify the portion of the royalty attributable to the foreign country imposing the tax (bifurcate the payment).
The regulations include certain documentation requirements (such as the agreement address these issues above), as well as anti-abuse provision so taxpayers do not try to change the agreement to only tax certain payments at a higher rate to make up for the lack of royalties from other countries running through the foreign corporation.
New Attribution Requirement
This requirement aims to ensure that destination-based taxes are not creditable taxes, as they lack sufficient nexus to the taxing jurisdiction. Destination-based taxes include digital services levies, which are based on a company’s digital, rather than physical, presence.
The required connection between a creditable foreign income tax and the foreign jurisdiction imposing the tax depends on whether the tax is levied on residents or nonresidents of the taxing jurisdiction.
Cost Recovery Requirement
The cost recovery requirement replaces the net income requirement. A foreign tax that is based on gross receipts is now creditable only if the foreign country provides cost recovery (in other words, a deduction) for costs and expenses, including:
- Capital expenditures
- Interest, excluding limitations similar to Section 163(j)
- Rents, royalties, wages or payments for services
- Research and experimentation
The character of a deduction is determined under foreign law. Foreign tax law satisfies this requirement even when deductions are disallowed for all or a portion of an expense, provided the disallowance is consistent with principles underlying disallowances required under the tax code.
For example, the foreign tax may limit interest deductions so as not to exceed 10% of a reasonable measure of taxable income, based on principles similar to those underlying Sec. 163(j).
However, if a foreign tax law disallows the deduction of one or more significant costs or expenses, and such disallowance is inconsistent with deduction limitations under the tax code, it appears the entire foreign tax is not creditable for any taxpayer, regardless of whether the disallowance is relevant in a taxpayer’s specific circumstances.
The proposed regulations address the “substantially all” standard for cost recovery, including a safe harbor and several examples. There is now a safe harbor where the substantially all test is met if the amount of an item disallowed does not exceed 25% of the item. There is also a “qualifying cap” safe harbor that allows the capping of deductions of a single item of significant cost or expense so long as the cap is not less than 15% of gross receipts or gross income or 30% tax taxable income. For example, if interest expense is caped at 15% of gross income or 30% of taxable income, then the safe harbor is met, and the cost recovery test is passed.
Steps to Take
To navigate the impact of these changes to the creditability rules for foreign income taxes, taxpayers should take the following three steps:
- Identify income or income-equivalent taxes paid to foreign jurisdictions.
- Evaluate whether such taxes remain creditable under the final or proposed regulations.
- Determine whether an income tax treaty between the United States and the foreign jurisdiction preserves creditability for a tax that might otherwise fail the creditability requirements under the final regulations.
- Review royalty agreements with foreign corporations in non-treaty countries and determine if “single-country license” agreements need to be concluded.
If you need assistance, our international tax advisors at Moore Doeren Mayhew can assist you execute these steps, as well as answer questions you might have about changes to the foreign tax credit. Contact us today.