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January 31, 2022

Law firm clients should take note aspects of new FTC regulations

Law firm clients should be aware that final foreign tax credit regulations (the "Final Regulations") published in January 2022 could have a significant impact on the creditability of taxes for entities operating in many sectors, including legal services. The Final Regulations will affect the creditability and basketing of a broad range of foreign taxes, including IRC Section 901 and 960 taxes (i.e., both direct and indirect taxes). Significantly, the Final Regulations include a new attribution requirement (termed the "jurisdictional nexus requirement" in the proposed regulations) and finalize Reg. Section 1.861-20 (re the allocation of foreign taxes), Reg. Section 1.905-1 (re the accrual of foreign taxes) and Reg. Section 1.245A(d)-1 (re the disallowance of certain credits and deductions under IRC Section 245A(d)).

Tax Alert 2022-0040 provides details on the Final Regulations. Law firm clients should pay particular attention to certain issues, highlighted below.

Transactions to Consider

  • Creditability of foreign tax by foreign branches that are subject to tax both in the US and in the foreign jurisdiction
  • Payments from foreign jurisdictions to the US where a withholding tax is imposed, particularly withholding tax related to services and/or royalties
  • Payments between foreign jurisdictions where there is a withholding tax related to services and/or royalties

General income taxes: the net gain requirement

  • Cost recovery requirement: The definition of what constitutes a creditable income tax has been modified to include more objective factors. In particular, the Final Regulations include a cost recovery requirement. 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. If a jurisdiction does not permit a tax deduction for these recoverable costs, the tax does not qualify as a net income tax. This determination is made regardless of whether the deduction would be applicable to the taxpayer's facts or industry. For example, if a taxpayer operates in a country that does not permit a royalty deduction for IP licenses, any taxes paid in that jurisdiction should not be creditable, even if the taxpayer does not pay any royalties
  • Attribution requirement: Due to the recent imposition of novel extraterritorial taxes generally targeted at the digital economy, the Final Regulations impose a new attribution requirement, which requires a sufficient connection between the foreign country imposing the tax and the non-resident taxpayer's activities or investments in the assessing country. Taxes paid will need to meet one of three requirements to be creditable:
    • Source based attribution — gross receipts and costs included in the foreign tax base are limited to gross income arising from sources within the foreign country, determined using sourcing rules that are reasonably similar to those under US law. Importantly, for the legal services industry the Final Regulations note that services income must be sourced based on where the services are performed and NOT based on residence of the payor
    • Activities based attribution — gross receipts and costs included in the foreign tax base are limited to those attributable to a non-resident's activities in the foreign country without taking into account the location of the customers/users or person from whom the nonresident makes purchases
    • Property situs attribution — gross receipts from sales or dispositions of property included in the foreign tax base include only gains from real property located in the jurisdiction or property that constitutes part of a business that creates a taxable presence in the foreign jurisdiction

Withholding taxes

  • For a withholding tax to be creditable, these requirements must be met:
    • The foreign jurisdiction must generally impose a net income tax as described above
    • The foreign tax must be a gross basis tax (even if not actually withheld at source) imposed on non-residents
    • Must satisfy a non-duplication standard (i.e., the tax should not apply to gross income of non-residents that is also subject to a net income tax imposed by the same jurisdiction)
    • Must satisfy the source-based attribution standard

Interaction with income tax treaties

  • The Final Regulations 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 US income tax treaty
  • On withholding and non-resident capital gains taxes assessed on controlled foreign corporations (CFC), treaties entered into between the CFC's country of incorporation and the residence of the payer can be taken into account in certain circumstances

Separately, the Final Regulations finalize the allocation of foreign taxes in Reg. Section 1.861-20. These rules provide specific allocations of taxes related to disregarded payments

  • Foreign taxes on disregarded payments made by or to a taxable unit are allocated to different credit baskets differently depending on the type of transactions performed
  • Covered by Reg. Section 1.861-20 include, among others
    • Contributions/downstream disregarded payments in excess of gross income
    • Regarded or disregarded stock sale with an IRC Section 964(e) amount
    • Significant remittances/distributions


Contact Information
For additional information concerning this Alert, please contact:
Law Firm Industry practice
   • Shelby Saad-Callahan (