January 10, 2022
Foreign tax credit regulations revamp creditability rules for foreign income taxes and include several other key changes
On 4 January 2022, the United States (US) Treasury Department published its third set of final regulations (T.D. 9959, the Final Regulations) on foreign tax credits since the enactment of the Tax Cuts and Jobs Act (TCJA). The Final Regulations adopt proposed regulations that were published on 12 November 2020 (the Proposed Regulations), with some modifications. For an Alert discussing the Proposed Regulations, see Tax Alert 2020-2645.
The Final Regulations fundamentally revamp the rules for determining the creditability of a foreign tax under IRC Sections 901 and 903, including by requiring a foreign tax to meet an attribution requirement (known as the "jurisdictional nexus requirement" in the Proposed Regulations). The Final Regulations also provide guidance on allocating and apportioning foreign taxes paid or accrued with respect to certain transactions that are disregarded for US federal tax purposes, the disallowance of a credit or deduction for certain foreign income taxes, when foreign income taxes accrue, and various issues relevant for determining a taxpayer's foreign tax credit limitation. Lastly, the Final Regulations narrow the scope of services that constitute electronically supplied services for purposes of the rules under IRC Section 250 on foreign-derived intangible income (FDII).
Creditable foreign income taxes
IRC Section 901 generally permits a taxpayer to claim a credit against its regular US tax liability for "income, war profits, and excess profits taxes" paid or accrued during a tax year to any foreign country or US possession. Under IRC Section 903, a tax paid in lieu of a generally imposed foreign income tax is treated as an income tax for purposes of IRC Section 901 (an in-lieu-of tax).
Under prior IRC Section 901 regulations, a foreign levy was treated as an income tax if (i) the foreign levy was a tax and (ii) the tax's character was predominantly that of an income tax in the US sense (the predominant character test). A foreign levy was a tax if it was a compulsory payment under a foreign country's authority to levy taxes. A payment was not compulsory to the extent it exceeded the taxpayer's tax liability under foreign law; thus, regulations generally required a taxpayer to reduce, over time, its reasonably expected foreign tax liability. This standard applied separately to each taxpayer. The predominant character test was generally met if the foreign tax was likely to reach net gain in the normal circumstances in which it applied (the net gain requirement).
The net gain requirement, in turn, was met if the foreign levy satisfied realization, gross receipts and net income requirements. The realization requirement was met if the foreign tax was imposed on or after a realization event in the US sense (or in certain instances, before a realization event); the gross receipts requirement was met if the foreign tax was imposed on the basis of gross receipts (or a proxy for gross receipts that was not likely to exceed gross receipts); and the net income requirement (renamed the "cost recovery requirement" in the Proposed Regulations) was met if the foreign tax law allowed for the recovery of significant costs and expenses (or provided a comparable allowance that equaled or exceeded those significant costs and expenses).
A foreign levy qualified as an in-lieu-of tax if the foreign levy was a tax and substituted for, rather than added to, an income tax or a series of income taxes otherwise generally imposed by the foreign country.
While Treasury and the IRS have retained the general regulatory framework for creditability (e.g., a foreign levy must be a tax and must be an income tax in the US sense), the Final Regulations significantly modify the requirements that a foreign tax must satisfy to be claimed as a credit. A detailed discussion of these changes follows:
Changes to the net gain requirement
The Final Regulations modify each element of the net gain requirement by replacing the "normal circumstances" standard with a more objective standard that would base the determination of whether the net gain requirement is met on the terms of the applicable foreign law. The Final Regulations also implement more restrictive tests with respect to each element of the net gain requirement, other than with respect to the realization requirement. The realization requirement follows prior law, but permits the foreign tax base to include an insignificant amount of gross receipts that do not meet the requirement. For example, a foreign tax imposed on imputed rent from owner-occupied housing may still qualify as a foreign income tax if, relative to all of the income of all taxpayers that are subject to the tax, the imputed rental income was insignificant.
Under prior law, the gross receipts requirement was met if the foreign tax was imposed on the basis of gross receipts, or a proxy for gross receipts that was not likely to exceed gross receipts (the Alternative Gross Receipts Test). The Final Regulations remove the Alternative Gross Receipts Test but permit the deemed gross receipts resulting from deemed realization events (e.g., those resulting from a mark-to-market regime) to still meet the gross receipts requirement if the deemed gross receipts are reasonably calculated to be at or below fair market value.
The cost recovery requirement under the Final Regulations is met if the foreign tax law (i) allows for the recovery of significant costs and expenses attributable to gross receipts in the foreign tax base or (ii) permits recovery of an alternative amount that by its terms may be greater, but never less, that the actual amounts of significant costs and expenses. The significance of the cost or expense is based on whether it constitutes a significant portion of the total costs and expenses of all taxpayers subject to the tax. The Final Regulations provide a list of "per se" significant costs and expenses, including capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation.
Foreign law applies to determine the character of a particular deduction. For instance, a foreign country's denial of a deduction for a payment made on an instrument treated as equity for foreign tax purposes but as debt for US purposes would not violate the net gain requirement. Additionally, provisions disallowing foreign law expense are permissible if the disallowance is consistent with the principles of the Code. For example, a foreign tax can meet the net gain requirement even if foreign law limits interest deductions or disallows interest and royalty deductions connected with hybrid transactions, based on principles similar to those underlying IRC Sections 163(j) and 267A, respectively. In addition, the Final Regulations also permit a foreign gross basis tax to satisfy the net gain requirement if (i) no significant costs and expenses are attributable to the gross receipts included in the foreign tax base, (ii) the foreign tax law does not permit recovery of any costs and expenses attributable to wage income or to investment income that is not derived from a trade or business, or (iii) no deduction is permitted for certain other taxes.
New "attribution requirement"
One of the most significant changes in the Final Regulations is a new "attribution requirement" (known as the "jurisdictional nexus requirement" under the Proposed Regulations), which a foreign income tax must satisfy to be creditable under IRC Section 901. The attribution requirement responds to novel extraterritorial taxes, which depart from traditional international tax norms by asserting taxing jurisdiction based on factors such as destination, customers and market access. This includes several digital services taxes that have been introduced in European and emerging-market jurisdictions. The attribution requirement has far-reaching effects and will impact the creditability of a wide range of foreign taxes.
Incorporated into the net gain requirement, the attribution requirement does not generally consider foreign taxes creditable unless the foreign law requires a sufficient connection between the foreign country and the taxpayer's activities or investments. That standard is met for a foreign income tax imposed on nonresidents of a foreign country only if one of the following three standards is met:
Stricter requirements for in-lieu-of taxes
The Final Regulations tighten the requirements that a foreign levy must satisfy to qualify as an in-lieu-of tax. Specifically, to qualify as an in-lieu-of tax, a foreign levy must be a foreign tax and must satisfy a substitution requirement. The foreign levy (referenced as a tested tax) satisfies the substitution requirement if (i) it is a covered withholding tax (discussed later), or if the following four tests are met, based on foreign law:
A covered withholding tax satisfies the substitution requirement. A tested tax is treated as a covered withholding tax if certain different, but partially overlapping, requirements are met. First, the foreign country must also apply a generally-imposed net income tax. Second, the tested tax must be a gross basis tax (whether or not it is actually "withheld" at source) that is imposed on non-residents of the foreign country. Third, it must satisfy a non-duplication standard similar to the one previously discussed. Finally, it must satisfy the Source-Based Attribution standard.
The Final Regulations include two examples (Treas. Reg. Section 1.903-1(d)(3) and (4)) that will be relevant for many taxpayers. Specifically, the examples illustrate the application of the covered withholding tax provisions to a withholding tax imposed on royalty income. A withholding tax imposed on royalty income is creditable only if the withholding tax liability is based on source, and the foreign tax law determines source "based on the place of use of, or the right to use, the intangible property" generating the royalty income. A withholding tax is not creditable if the country imposes the withholding tax because the royalty is paid by a resident to a non-resident — even if the underlying intangible property is, in fact, used solely within the payor's country.
The rules treat withholding taxes as separate levies for each class of income subject to the tax or each subset of a class of income that is subject to different income attribution rules. Thus, a withholding tax that fails to satisfy one of the foregoing requirements for one class of gross income (for example, royalties) may be creditable for other classes of gross income (for example, dividends, interest, etc.).
Interaction with income tax treaties
In a helpful clarification, the Final Regulations explicitly provide that a foreign levy treated as an income tax under an applicable US income tax treaty qualifies as a "foreign income tax" if paid by a US citizen or resident that elects benefits under the treaty. Because CFCs are not treated as US residents under US income tax treaties, CFCs that are resident in a third country do not qualify for benefits under US treaties. Thus, the Final Regulations clarify that taxes paid to a US treaty partner by a third-country CFC are separate levies that must independently satisfy the requirements of IRC Sections 901 or 903. However, certain modifications to which the foreign country has agreed under its treaties with other jurisdictions may be considered.
Amount of tax considered paid
The Final Regulations modify current law on determining the amount of foreign tax considered paid. For instance, a taxpayer that reduces its foreign income tax liability with a foreign law tax credit has not paid foreign tax eligible for a credit (even if the foreign law tax credit is refundable, for example). Exceptions apply to certain overpayments and other fully refundable credits.
Subject to various exceptions, the Final Regulations determine whether a payment is compulsory (which is required for the payment to be a tax) based on whether the foreign tax law includes options or elections to permanently decrease a foreign income tax liability in the aggregate over time; a taxpayer's failure to use these options or elections may result in a noncompulsory payment. Exceptions to this revised standard include a taxpayer's election to (i) treat an entity as fiscally transparent or non-fiscally transparent under foreign tax law; (ii) file a foreign consolidated return; or (iii) share losses under a foreign group relief or other loss-sharing regime. The Final Regulations provide an additional exception for certain transactions that increase one person's foreign income tax liability but reduce another person's foreign income tax liability (by a greater amount) through the deactivation of foreign law hybrid mismatch rules.
The Final Regulations adopt, without significant change, the Proposed Regulation's rule allocating foreign taxes among two or more persons when a partnership, disregarded entity, or corporation undergoes one or more "covered events" during its foreign tax year that do not close the foreign tax year. In those cases, a portion of the foreign taxes (other than withholding taxes) paid or accrued by the technical taxpayer would be allocated among all persons that were predecessor entities or prior owners during the foreign tax year. A covered event includes (i) a partnership termination under IRC Section 708(b)(1); (ii) a transfer of a disregarded entity; or (iii) a disregarded entity changing to a corporation (or vice-versa). Similarly, a change in a partner's interest in a partnership (a variance) may also require an allocation of the taxes.
If a foreign corporation elected to be disregarded from its single owner, the Final Regulations would partially allocate to the predecessor entity (the foreign corporation) any foreign taxes that otherwise would be treated as paid or accrued by the single owner.
The Final Regulations under IRC Sections 901 and 903 apply to foreign income taxes paid or accrued in tax years beginning on or after December 28, 2021. However, applicability is deferred for Puerto Rico's expanded effectively-connected-income regime (section 1123 of the Puerto Rico Internal Revenue Code of 1994) and excise tax on certain goods and services (section 2101 of the Puerto Rico Internal Revenue Code of 1994),1 with the Final Regulations only applying to those foreign taxes paid or accrued in a tax year beginning on or after January 1, 2023.
Rules addressing when an accrual-basis taxpayer can claim an FTC
The Final Regulations formally adopt the modified all-events test under IRC Section 461, which provides that foreign income taxes accrue upon the occurrence of all events that establish both the fact of, and the amount of, the liability.2 Additionally, the Final Regulations incorporate the relation-back doctrine, which specifies that foreign income taxes accrue at the close of the year to which those taxes relate (the relation-back year).3 Accordingly, a contested foreign tax generally does not accrue until the underlying dispute is resolved but would be considered to accrue at the close of the relation-back year and not the year in which the dispute is resolved. For example, if a taxpayer resolved a foreign tax settlement in 2022, and paid additional foreign tax for its 2019 tax year as a result of that settlement, that additional tax liability for 2019 accrues in 2022, but relates back to 2019, so it affects the taxpayer's 2019 foreign tax credit and other US tax items.
The Final Regulations replace existing administrative guidance and provide elective relief in the form of a "provisional credit" for the portion of contested taxes paid. To claim the provisional credit, the taxpayer must agree to (i) notify the IRS once the contest is resolved, (ii) attach an annual notice to its timely-filed return until that time, and (iii) not assert the limitation period on assessment for three years from the later of the filing or the due date (with extensions) of the return for the tax year in which the taxpayer notifies the IRS that the contest has been resolved.
These provisions were finalized without any significant changes. The Final Regulations did, however, further clarify that the provisional credit can be elected only for contested taxes that relate to a tax year in which the taxpayer previously elected to claim a foreign tax credit. Additionally, the Final Regulations eliminated a proposed provision that would have deemed a failure to comply with the annual reporting requirements for the provisional credit to be a refund to the taxpayer equal to the contested taxes. In the Preamble to the Final Regulations, Treasury noted that a taxpayer that failed to comply would have nonetheless deferred the applicable statute of limitation, allowing the IRS additional time to assess an underpayment relating to the provisional credit.
Accrual of foreign income taxes for a 52-53-week US tax year
Generally, a foreign income tax accrues in the US tax year in which or with which the foreign tax year ends. The Final Regulations treat a 52-53-week US tax year that closes within six calendar days of the taxpayer's foreign tax year as ending on the last day of the foreign tax year for purposes of determining the foreign income taxes that accrue with or within the 52-53-week tax year. This rule resolves mismatches with 52-53-week US tax years that cause foreign taxes not to accrue within certain US tax years (because no foreign tax year ends within that period) and other years to have two years' worth of accrued foreign income taxes (because two foreign year-ends fall within that period). This provision was finalized without any change from its proposed form.
Correcting improper methods of accounting for foreign income taxes
A taxpayer's method of accruing foreign income taxes is a method of accounting. Accordingly, a taxpayer must obtain IRS consent to change from an improper method of accruing foreign income taxes (for example, by accruing foreign income taxes in a year other than the tax year in which the all-events test is satisfied, or failing to follow the relation-back rule) to the proper method of accruing foreign income taxes. Taxpayers must file a Form 3115, Application for Change in Accounting Method, to obtain permission to change from an improper method of accruing foreign income taxes to the proper method.
The Final Regulations provide a "modified cut-off" approach to adjust foreign income taxes claimed as a credit or deduction in a year in which an accounting method change is made. Under this approach, a taxpayer would generally adjust the amount of foreign income tax that can be claimed as a credit or deduction in the year of change (in each statutory or residual grouping under IRC Section 904(d)) as follows:
Special rules apply for purposes of allocating remittances of foreign income taxes to a foreign country and the application of the foreign tax redetermination rules under IRC Section 905(c).
Deductions allowed in tax years in which a foreign tax credit is claimed
IRC Section 275(a)(4) prohibits taxpayers from deducting foreign income taxes for which they elect to claim a credit (even if a credit is limited under IRC Section 904(a)). If a taxpayer chooses, for any tax year, to claim a credit for foreign income taxes paid or accrued to any extent, the existing regulations under IRC Section 901 apply that choice to all foreign income taxes paid or accrued in that year (including foreign taxes that relate to a prior tax year) and prohibit the taxpayer from deducting those taxes. The Final Regulations modify this rule to allow an accrual-basis taxpayer electing to claim a credit for foreign income taxes for the year to deduct foreign income taxes that are paid in that year but relate to a prior year in which the taxpayer deducted foreign income taxes.
Changing from deducting to crediting foreign income taxes (and vice-versa)
The Final Regulations clarify that the period during which a taxpayer may choose or change its election to claim a foreign tax credit or deduct the foreign tax expense is based on the refund period specific to the choice that taxpayer makes. Accordingly, these rules require taxpayers to elect to claim a credit (or change from a deduction to a credit) for foreign income taxes paid or accrued in a tax year before the 10-year refund limitation period under IRC Section 6511(d)(3) expires for that year. In contrast, taxpayers must elect to claim a deduction (or change from credit to deduction) for foreign income taxes paid or accrued in a tax year before the three-year refund limitation period under IRC Section 6511(a) expires for that year.
The Final Regulations further expand the definition of a foreign tax redetermination under IRC Section 905(c) to treat a change from deducting foreign income taxes to claiming a credit for foreign income taxes (and vice-versa) as a foreign tax redetermination. This expansion allows the IRS to assess and collect tax deficiencies resulting from change in election, even if the three-year limitation period has expired under IRC Section 6501(a). For example, the IRS would be permitted to assess a deficiency if a taxpayer elects to credit foreign income taxes that were originally deducted in a prior year, and the deduction had created or increased an NOL deduction that was carried to an earlier tax year and otherwise would be time-barred by the statute of limitations.
Rules addressing when a cash-basis taxpayer can claim a foreign tax credit
Generally, taxpayers that use the cash method of accounting may credit foreign income taxes in the tax year in which those foreign income taxes are accrued if an election is made. The Final Regulations under IRC Section 905 require the election to be made on an original tax return unless the taxpayer has never claimed a foreign tax credit; in that case, the election may also be made on a properly amended tax return. In either case, the election is irrevocable once made. A cash method taxpayer that claimed foreign tax credits on a cash basis in a prior tax year may also claim a foreign tax credit for foreign income taxes that:
Rules addressing foreign tax expenditures of partnerships
A partner may claim its distributive share of foreign income taxes paid or accrued by the partnership, during the partnership's tax year ending with or within the partner's tax year. A partner's distributive share of foreign income taxes is determined under the partnership's accounting methods. Accordingly, a cash method partner may claim a credit (or deduction) for its distributive share of foreign income taxes accrued by an accrual method partnership in the partner's taxable year with or within which the partnership's tax year ends.
The Final Regulations provide elective relief to a partner to claim a "provisional credit" for that partner's distributive share of the contested taxes remitted by the partnership either (i) in the year the partnership remits the tax for cash-basis partners, or (ii) in the relation-back year for accrual-basis partners. To claim the provisional credit, the partner must also comply with the provisional credit notification requirements and agree to not assert the limitation period on assessment, as discussed previously.
The Final Regulations under IRC Section 905 apply to foreign income taxes paid, accrued, or remitted, as applicable, in tax years beginning on or after December 28, 2021.
Treas. Reg. Section 1.861-20: Allocation and apportionment of foreign income taxes
Foreign income taxes paid or accrued by a taxpayer are allocated and apportioned to statutory or residual groupings based on the statutory or residual groupings to which a taxpayer's foreign gross income is assigned. If a US gross income item arises from the same transaction or other realization event as the foreign gross income item (a corresponding US item), then the foreign gross income item is assigned to statutory and residual groupings based on the groupings to which the corresponding US item would be assigned. Special rules apply for certain specific foreign gross income items.
The Final Regulations contain rules for allocating and apportioning foreign income taxes imposed on (i) dispositions of stock and partnership interests and certain partnership distributions; (ii) disregarded payments made between "taxable units;" and (iii) US equity hybrid instruments.
Dispositions of stock and partnership interests
The Final Regulations assign foreign income taxes from a transaction treated as a sale, exchange or other disposition of stock for US tax purposes first to the same category as the corresponding US dividend amounts (e.g., IRC Sections 1248 or 964(e) amounts). Foreign law gain that exceeds the US dividend is assigned to the same category as the US capital gain (to the extent thereof). Any foreign gross income that exceeds the US dividend and US capital gain is assigned to groupings based on the tax book value of the transferred corporation's stock, as determined under the asset method of Treas. Reg. Section 1.861-9. Similarly, foreign income taxes associated with the sale of a partnership interest, or a distribution from a partnership under IRC Section 733, are assigned first to the same grouping as the corresponding US capital gain amount (to the extent thereof); any foreign gross income exceeding the US capital gain amount is assigned based on the tax book value of the partnership interest, or the partner's pro rata share of partnership assets (as applicable) under Treas. Reg. Section 1.861-9(e).
The Final Regulations allocate and apportion to statutory or residual groupings foreign gross income, and foreign income taxes on that gross income, resulting from a disregarded payment made to or by a taxable unit. A disregarded payment includes an amount of property that is transferred to or from a taxable unit in connection with a transaction that is disregarded for Federal income tax purposes and that is reflected on the separate set of books and records of the taxable unit, including:
For individuals or domestic corporations, a taxable unit is a foreign branch, a foreign branch owner or a non-branch taxable unit (which may include a disregarded entity that does not conduct a trade or business). For foreign corporations, a taxable unit is a tested unit, as determined under the high-tax exclusion regulations of IRC Section 951A.
Different rules apply depending on whether the disregarded payment is a reattribution payment, a remittance, a contribution or a disregarded sale. A reattribution payment is the portion of a disregarded payment equal to the sum of all reattribution amounts that are attributed to the recipient of the disregarded payment. A reattribution amount is an amount of gross income that is, by reason of a disregarded payment made by that taxable unit, attributed to another taxable unit. Generally, a disregarded payment causes gross income to be attributed to another taxable unit to the extent that a deduction for the payment, if regarded, would be allocated against the payor tested unit's US gross income.5
A payee taxable unit's foreign gross income arising from the disregarded payment is then assigned to categories based on the federal income tax characterization of the reattribution amount. For example, passive category gross income of a payor taxable unit is reattributed to a payee taxable unit if the payor taxable unit makes a disregarded payment that, if regarded, would have been allocated to that passive category gross income. The payee taxable unit's foreign gross income (and ultimately the foreign income taxes) arising from the disregarded payment is then assigned to the same categories as the payor taxable unit's US gross income that was reattributed (entirely passive category income in this example). Disregarded payments made by the payor taxable unit, however, do not affect the allocation and apportionment of the payor's taxes. In other words, the foreign gross income and associated foreign income taxes of a payor taxable unit are categorized before giving effect to reattribution amounts.
A second set of rules apply to disregarded payments treated as remittances. Foreign income taxes paid on remittances are treated as having been paid ratably out of all the accumulated after-tax income of the taxable unit. The after-tax income of a taxable unit is deemed to arise in the statutory and residual groupings in the same proportions that the tax book value of the taxable unit's assets would be assigned under the asset method of Treas. Reg. Section 1.861-9. A taxable unit's assets are determined under the principles of Treas. Reg. Section 1.987-6(b) but include stock and certain assets of other taxable units to the extent gross income of those taxable units has been reattributed to the taxable unit treated as making the remittance. A taxable unit's assets also include its pro rata share of the assets of another taxable unit (e.g., a disregarded entity or partnership) in which it owns an interest.
The Final Regulations simplify the definitions of the terms "contribution" and "remittance" so that, together, they describe all payments that are not reattribution payments. A contribution is defined as the excess of a disregarded payment made by a taxable unit to another taxable unit that the first taxable unit owns over the portion of the disregarded payment that is a reattribution payment. For example, if a CFC made a $100x disregarded payment to a disregarded entity that it owned, and $90x of the disregarded payment would reattribute gross income from the CFC to the disregarded entity, the remaining $10x is treated as a contribution. Foreign income taxes arising from disregarded payments treated as contributions are allocated to the residual grouping, meaning a credit is effectively denied if the taxpayer is a CFC.
A remittance means a disregarded payment that is neither a contribution nor a reattribution payment. For example, if a disregarded entity made a $100x disregarded payment to a CFC owner of the disregarded entity, and $90x of the disregarded payment would reattribute gross income from the disregarded entity to the CFC, then the remaining $10x of the disregarded payment is treated as a remittance.
Finally, a foreign law income item arising from a disregarded sale or exchange of property is assigned to statutory or residual groupings by reference to the grouping to which a corresponding US item (i.e., built-in gain in the property) would have been assigned if the sale were recognized under Federal income tax law.
US equity hybrid instruments
The Final Regulations introduce a new special rule for allocating and apportioning foreign income tax on foreign gross income included by a taxpayer by reason of its ownership of a US equity hybrid instrument. A US equity hybrid instrument is an instrument that is stock or a partnership interest for US federal income tax purposes but is debt (or otherwise gives rise to the accrual of income that is not treated as a dividend or a distributive share of partnership income) under foreign law. Generally, foreign gross income (and ultimately the foreign income taxes) paid to or accrued by a taxpayer with respect to a US equity hybrid instrument is assigned to statutory and residual groupings as if the transaction were a taxable distribution of property for US federal income tax purposes.
Effective date: The Final Regulations under Treas. Reg. Section 1.861-20 generally apply to tax years that begin after December 31, 2019, and that end on or after November 2, 2020.
IRC Section 245A(d)
Denial of foreign tax credit and deduction for certain foreign income taxes
IRC Section 245A(d) prohibits taxpayers from claiming credits or deductions for foreign income taxes paid or accrued (or treated as paid or accrued) on dividends for which an IRC Section 245A deduction is allowed. Under IRC Section 245A(e)(3), the same rules apply to foreign income taxes paid or accrued (or treated as paid or accrued) on hybrid dividends (or tiered hybrid dividends).
The Final Regulations disallow a credit or deduction for foreign income taxes that are paid or accrued by a taxpayer and attributable to "IRC Section 245A(d) income" (for a domestic corporation, certain successors of a domestic corporation, or a foreign corporation) or "non-inclusion income" (solely for a domestic corporation).
IRC Section 245A(d) income
For a domestic corporation, IRC Section 245A(d) income includes (i) a dividend or subpart F inclusion for which a deduction under IRC Section 245A is allowed; (ii) a distribution of "IRC Section 245A(d) previously tax earnings and profits (PTEP)"; (iii) a hybrid dividend; or (iv) an inclusion related to a tiered hybrid dividend. For a foreign corporation, IRC Section 245A(d) income means (i) subpart F income that gives rise to an inclusion for which a deduction under IRC Section 245A is allowed; (ii) a tiered hybrid dividend; or (iii) a distribution of IRC Section 245A(d) PTEP. For a successor, IRC Section 245A(d) income includes solely a distribution of IRC Section 245A(d) PTEP.
A successor is any person, including an individual who is a citizen or resident of the United States, that acquires from another person a portion of the interest of a United States shareholder in a foreign corporation for purposes of IRC Section 959(a). IRC Section 245A(d) PTEP is the PTEP of a foreign corporation resulting from (i) a sale or exchange of stock subject to IRC Sections 964(e)(4) or 1248 for which an IRC Section 245A deduction was allowed; or (ii) a tiered hybrid dividend that gave rise to an income inclusion to a US shareholder.
The Final Regulations attribute foreign income taxes to IRC Section 245A(d) income under the provisions of Treas. Reg. Section 1.861-20 (as modified by the Final Regulations), which allocate foreign income taxes to statutory and residual groupings, including for purposes of IRC Section 245A(d). For example, assume that FC, a foreign corporation, paid a dividend to USP, its US shareholder. The dividend was eligible for a deduction under IRC Section 245A, and the dividend was also subject to a foreign withholding tax. Treas. Reg. Section 1.861-20(d)(3)(i)(B)(2) would assign the foreign law dividend to the same statutory grouping (the IRC Section 245A(d) income group) as the US dividend amount, which is the IRC Section 245A(d) income group. As a result, the foreign withholding tax would be attributed to IRC Section 245A(d) income, and USP would not be eligible to claim a credit or deduction for the foreign withholding tax.
Non-inclusion income is all income of a foreign corporation other than subpart F income, tested income, and certain post-1986 undistributed US earnings. Foreign income taxes can only be attributable to non-inclusion income if the taxes are allocated and apportioned under Treas. Reg. Section 1.861-20 by reference to (i) the characterization of the tax book value of stock (as determined under Treas. Reg. Section 1.861-13); or (ii) the income of a foreign corporation that is a reverse hybrid or foreign law CFC.When apportioned by reference to the tax book value of stock, foreign income taxes are attributable to a foreign corporation's non-inclusion income only to the extent that they are allocated and apportioned to an IRC Section 245A subgroup of the foreign corporation's stock.
Consequently, foreign income taxes can be attributable to non-inclusion income and disallowed as the result of various transactions, including those resulting in a (i) remittance; (ii) distribution (including a foreign law distribution) that is a US return of capital amount; (iii) US return of partnership basis amount; or (iv) disposition (including a foreign law disposition) that gives rise to a US return of capital amount or a US return of partnership basis amount.
For example, assume that USP, a domestic corporation, is a United States shareholder of FC, a foreign corporation resident in Country X. FC makes a distribution to USP that is a dividend for foreign law purposes but a US return of capital amount for federal income tax purposes. Country X withholds tax from the distribution. Under Treas. Reg. Section 1.861-20(d)(3)(i)(B)(2), the foreign withholding tax is assigned to statutory groupings in the same proportions as the proportions in which the tax book value of the FC stock is assigned under the asset method in Treas. Reg. Section 1.861-9. Under the Final Regulations, if 30% of FC's stock is attributable to an IRC Section 245A subgroup (e.g., due to FC's tested income that is not included in income by USP by reason of QBAI or tested losses), then 30% of the foreign withholding taxes paid by USP on the distribution would be attributable to non-inclusion income. Consequently, no credit or deduction would be allowed for 30% of foreign income taxes paid on the distribution.
As a backstop to the general rules, an anti-avoidance rule attributes foreign income taxes to IRC Section 245A(d) income or non-inclusion income if a transaction, series of transactions or arrangement is undertaken with a principal purpose of avoiding the purposes of IRC Section 245A(d) with respect to those taxes.
Treas. Reg. Section 1.245A(d)-1 applies to tax years beginning after December 31, 2019 and ending on or after November 2, 2020.
Foreign branch income
The Final Regulations clarify certain aspects of the disregarded payment rules applicable to foreign branches, including by adopting rules regarding the treatment of disregarded payments made to or by "non-branch taxable units." A non-branch taxable unit includes a disregarded entity that does not conduct a trade or business and the entity's owner.
The Final Regulations also include an example clarifying the interaction of the matching rule in Treas. Reg. Section 1.1502-13(c) and the disregarded payment rules. Generally, Treas. Reg. Section 1.1502-13(c) requires the attributes of intercompany transactions (including licenses, services, and sales of property among consolidated group members) to be redetermined to produce the same effect on consolidated taxable income as if the members of the consolidated group were divisions of a single corporation. When a foreign branch held by one member of a consolidated group transacts with another member of a consolidated group, the example demonstrates an instance in which the IRC Section 904(d) category of the regarded items from the transaction must be determined as though each member of the consolidated group were a division of a single corporation (i.e., by reference to the disregarded payment rules).
The Final Regulations apply to tax years beginning after December 31, 2019 and ending on or after November 2, 2020.
Source of inclusions under IRC Sections 951, 951A, and 1293 and related dividends under IRC Section 78
The Final Regulations determine the source of subpart F income, GILTI, certain passive foreign investment companies' inclusions and associated IRC Section 78 dividends by treating those amounts as a dividend received by the US shareholder directly from the relevant foreign corporation.
Effective date: The Final Regulations addressing these sourcing issues apply to tax years that end on or after November 2, 2020.
The Final Regulations finalize, without modification, Proposed Regulations providing that loans made from one CFC to a related CFC (CFC-to-CFC-debt) are generally not treated as related-group indebtedness (RGI) for purposes of the CFC netting calculation and are excluded from related group indebtedness for purposes of determining the foreign base period ratio.
The Final Regulations are effective for the CFC netting calculation for tax years ending on or after November 2, 2020
R&E expense capitalization and bank interest expense provisions
The Final Regulations do not finalize certain provisions in the Proposed Regulations, including: (i) an election to capitalize and amortize IRC Section 174 research and experimental expenses and advertising expenses for purposes of allocating and apportioning interest expense under Treas. Reg. Section 1.861-9; and (ii) special rules for allocating and apportioning interest expense to foreign branch category income for financial institutions. The Preamble to the Final Regulations notes that Treasury and the IRS are continuing to study the comments received in connection with those provisions.
The Final Regulations finalize, without significant changes, Proposed Regulations under IRC Section 250 regarding the definition of electronically supplied services for FDII purposes. The Final Regulations clarify that electronically supplied services are services delivered primarily over the internet or an electronic network for which the value to the end user is derived primarily from the service's automation or electronic delivery (e.g., the streaming of digital content). The Final Regulations specify that these services would generally exclude services that primarily involve the application of human effort by the renderer through the internet or an electronic network, such as legal, accounting, medical or teaching services. The Final Regulations apply to tax years beginning on or after January 1, 2021.
Taxpayers should carefully consider how the new requirements for crediting a foreign tax, particularly the attribution requirement, affect their abilities to claim a credit for foreign taxes incurred. Many novel extraterritorial taxes, such as digital services taxes and equalization levies, whether or not creditable under prior law, are likely to fail the attribution requirement. But the scope of the Final Regulations is far broader, even though they were formulated in response to novel extraterritorial taxes. Many taxes that are less novel — particularly withholding taxes imposed on royalties and services — may not be creditable under the Final Regulations, particularly withholding taxes imposed in many emerging markets where there may be no double tax treaty relief. Those changes will have far-reaching implications for taxpayers across all industries.
The Final Regulations' rules on allocating and apportioning foreign income taxes are complex, and pose significant compliance challenges. Although the rules provide detailed guidance, difficult interpretational issues arise in many common scenarios, such as a taxpayer with multiple disregarded payments. The rules can lead to surprising results, including the loss of foreign tax credits in certain cases.
The Final Regulations under IRC Section 245A(d) offer significantly more clarity than the Proposed Regulations. Taxpayers should carefully consider how those rules can apply to disallow a credit for foreign taxes incurred. In certain cases, the same earnings and profits may result in a disallowance of a credit or deduction for foreign income taxes in multiple transactions.
1 The provisions implementing the effectively connected income rules and the excise tax were incorporated into sections 1035.05 and 3070.01, respectively, of the Puerto Rico Internal Revenue Code of 2011.
2 Treas. Reg. Section 1.905-1(d)(1)(i).
3 Treas. Reg. Section 1.905-1(d)(1)(ii).
4 A disregarded payment also includes any other amount that (i) is reflected in a separate set of books and records of a taxable unit; (ii) relates to a transaction that is disregarded for Federal income tax purposes; and (iii) would constitute an item of accrued income, gain, deduction or loss of the taxable unit if the transaction to which the amount is attributable were regarded for Federal income tax purposes. For example, a disregarded distribution of a note, which would not be "property" because it is disregarded, is also treated as a disregarded payment.
5 Individuals and domestic corporations determine reattribution amounts under the foreign branch category rules, which generally attribute gross income to taxable units based on books and records, as modified to reflect Federal income tax principles. Gross income attributable to a foreign branch (or its owner or certain non-branch taxable units, including disregarded entities) may be reattributed based on certain disregarded payments between a foreign branch and its owner, or another foreign branch, to the extent the disregarded payments would, if regarded, give rise to a deduction that would be allocated and apportioned to the payor's gross income under existing expense apportionment rules (i.e., Treas. Reg. Sections 1.861-8 through 14 & 1.861-17 (subject to certain modifications)). CFCs and other foreign corporations determine reattribution amounts under the high-tax exclusion regulations, which generally follow the principles of the foreign branch category rules, subject to certain modifications. In particular, disregarded payments of interest may reallocate gross income to the extent the payments are deductible under foreign law.