November 25, 2022
Proposed foreign tax credit regulations offer relief from cost recovery and source-based attribution rules and include other key changes
In proposed regulations published November 22, 2022 (REG-112096-22; Proposed Regulations), the United States (US) Treasury Department addresses the definition of a foreign income tax and the allocation and apportionment of foreign taxes on disregarded payments. The Proposed Regulations would provide certain relief from the cost recovery requirement and the source-based attribution requirement on royalty income for purposes of determining the creditability of foreign taxes under Internal Revenue Code (IRC) Sections 901 and 903. The Proposed Regulations also would modify the disregarded payment rules for purposes of allocating and apportioning foreign taxes under IRC Section 861.
The Proposed Regulations would modify the final foreign tax credit regulations published on January 4, 2022 (TD 9959; 2022 Final Regulations), as amended by technical corrections published on July 27, 2022 (87 FR 45018 & 87 FR 45021; Technical Corrections). For Alerts discussing the 2022 Final Regulations and the Technical Corrections, see Tax Alerts 2022-0040 and 2022-1179, respectively.
Creditable foreign income taxes - Cost recovery requirement
Before the 2022 Final Regulations, the regulations under IRC Section 901 treated a foreign levy as an income tax, and thus creditable, if and only if (i) it was a tax, and (ii) the predominant character of that tax was that of an "income tax in the US sense." Under this rule, the tax met the second, predominant character prong if, among other requirements, it was "likely to reach net gain in the normal circumstances in which it applie[d]" (the net gain requirement).
The 2022 Final Regulations fundamentally revamped the net gain requirement for determining the creditability of a foreign tax under IRC Sections 901 and 903 while creating uncertainty as to whether many foreign taxes that were traditionally creditable under those provisions continued to be creditable. Under the 2022 Final Regulations, a tax met the net gain requirement only if it satisfied the realization requirement, the gross receipts requirement, the cost recovery requirement and the attribution requirement.
One of the most significant changes to the net gain requirement was made to the cost recovery requirement, which required a foreign tax law to allow for the recovery of "significant costs and expenses" attributable to gross receipts in the foreign tax base (with costs and expenses for capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation being treated as "per se" significant costs and expenses).
The 2022 Final Regulations provided an exception under which a foreign tax would not fail to satisfy the cost recovery requirement when the foreign tax law disallowed the recovery of certain costs and expenses if that disallowance was "consistent with the principles underlying the disallowances required under the Internal Revenue Code, including disallowances intended to limit base erosion or profit shifting" (the principles-based exception). The cost recovery rules under the 2022 Final Regulations raised numerous interpretive questions because foreign countries' tax laws include varied disallowances for costs and expenses; taxpayers often had difficulty determining whether a disallowance was consistent with the principles underlying one or more limitations in the IRC.
The Technical Corrections were intended to address these issues by, among other things, permitting the disallowance of all or a portion of certain costs or expenses so long as it is consistent with "any principle underlying the disallowances required under the [IRC]," including "the principles limiting base erosion or profit shifting and public policy concerns." The replacement of "the principles" with "any principle" and the addition of "public policy concerns" broadened the scope of permissible disallowances under the cost recovery requirement.
The Technical Corrections, however, still left many questions unanswered. For instance, it was unclear whether certain limitations on foreign deductions, such as those for stock-based compensation, would meet the amended cost recovery requirement.
The Proposed Regulations would make two significant changes to the cost recovery requirement. First, a foreign tax law would only need to allow for recovery of "substantially all" of each item of significant cost or expense, regardless of what the principles underlying any disallowances are. This "substantially all" determination would apply based on the foreign tax law (not a particular taxpayer's individual facts).
For purposes of applying the "substantially all" test, the Proposed Regulations introduce two safe harbors. The first would treat the foreign tax as not failing the "substantially all" test if the underlying foreign tax law disallows no more than 25% of one or multiple items of significant cost and expense. The second would treat the foreign tax as not failing the "substantially all" test if the underlying foreign tax law limits recovery of a single item of significant cost or expense or multiple items that relate to a single category of significant costs or expenses based on a "qualifying cap." A qualifying cap is defined as a foreign tax law that caps cost recovery based on no less than 15% of gross receipts, gross income, or a "similar measure." A qualifying cap also includes a foreign tax law that caps cost recovery based on no less than 30% of taxable income or a similar measure.
Second, even if a disallowance fails to meet the "substantially all" test, the Proposed Regulations would not prevent a foreign tax from satisfying the cost recovery requirement if the disallowance is consistent with the principles-based exception. The Proposed Regulations would modify this exception in two respects. First, the Proposed Regulations would require the disallowance to be "consistent with any principle underlying the disallowances required under the income tax provisions of the Internal Revenue Code." Second, while the 2022 Final Regulations (as modified by the Technical Corrections) state that such principles include "the principles of limiting base erosion or profit shifting and public policy concerns," the Proposed Regulations would strike the reference to "public policy concerns" and refer instead to "addressing non-tax public policy concerns similar to those reflected in the Internal Revenue Code."
The Proposed Regulations introduce several additional examples illustrating the application of the two safe harbors under the "substantially all" test and the amended principles-based exception. In particular, one of the examples concludes that a deduction disallowance for stock-based compensation does not cause a foreign tax to fail the cost recovery requirement because the foreign tax law's disallowance is consistent with certain non-tax public policy reasons reflected in the IRC, such as IRC Sections 162(m) and 280G.
The amended cost recovery rules under the Proposed Regulations are expected to provide more certainty as to whether the cost recovery requirement would be satisfied for specific foreign taxes.
The two safe harbors are mechanical and do not require a subjective analysis of the principle underlying a country's cost recovery disallowances. Taxpayers should consider the new safe harbors' impact on several existing foreign taxes, such as a foreign tax that requires adding 25% of otherwise deductible interest to the tax base (and a lesser percentage of other expenses with embedded financing costs).
A deduction disallowance that falls outside either of the safe harbors may still meet the general "substantially all" test (without resorting to the principles-based exception). However, the Proposed Regulations do not provide any guidance as to how to interpret the term "substantially all" outside the context of the explicit safe harbors, other than basing the "substantially all" determination on the terms of the foreign tax law.
The revisions to the language in the principles-based exception would subtly change the scope of the exception. That the Proposed Regulations would require the foreign tax law disallowance to be consistent with any principle underlying those in the "income tax provisions" of the IRC seems to preclude analogizing to principles in the non-income tax provisions of the IRC (e.g., penalty or excise tax provisions), an argument that appears permissible under the 2022 Final Regulations (as revised by the Technical Corrections).
In addition, it appears that the Proposed Regulations attempt to clarify that both non-tax and tax public policy considerations can be taken into account. Instead of referencing "public policy concerns," the Proposed Regulations replace the reference with "addressing non-tax public policy concerns similar to those reflected in the Internal Revenue Code." The Preamble explains that this rule is intended to clarify that any non-tax public policy concern underlying a foreign tax law disallowance "must be similar to the non-tax public policy concerns reflected in the Code."
New Examples 9 and 10 are significant additions to the regulations, illustrating what considerations do, and do not, need to be taken into account under the revised principles-based exception. Under Example 10, the facts simply state that the foreign country does not permit a deduction for stock-based compensation, without further elaboration. No facts or assumptions are included as to the principle underlying the foreign country's disallowance of stock-based compensation. Moreover, the foreign country's limitation does not mirror any Code-based limitation. Nevertheless, the example's analysis references two Code provisions (IRC Sections 162(m) and 280G) that disallow deductions for compensation, neither of which is specific to stock-based compensation; the example notes that both IRC provisions are based on non-tax public policy reasons. The example then states that the foreign country's disallowance also "reflects a principle of influencing the amount or use of a certain type of compensation (stock-based compensation) in the labor market." It is unclear whether this statement is intended to be a fact or assumption (despite not appearing in the example's Facts section), or if it is intended to be inferred based on the mere existence of the country's disallowance of stock-based compensation. Example 9, addressing a foreign country's anti-hybrid rules, illustrates an approach consistent with that under Example 10: the example's analysis references IRC Section 267A, which disallows deductions based on the principle of limiting base erosion or profit shifting, and then states that the foreign country's hybrid rules "also reflect" the same principle.
These examples seem to provide a favorable roadmap for analyzing a particular foreign country's deduction disallowances by identifying a principle in the IRC that is reasonably analogous to the foreign country's disallowance, identifying a principle behind that IRC provision and then concluding that the foreign country's disallowance is based on a similar principle. This analytical approach suggests that the rule may not require taxpayers to discern the actual principle or policy concern behind a disallowance under foreign law, which can often be difficult due to the absence of foreign legislative history.
Apart from these considerations, the fact that Example 10 permits analogizing disallowance of stock-based compensation to any compensation-based disallowance under the IRC suggests that taxpayers can take a very broad approach to determining whether a particular disallowance is "consistent with" a principle in the IRC.
Creditable foreign income taxes — Source-based attribution requirement
The 2022 Final Regulations treat a foreign withholding tax as creditable under IRC Section 903 if it meets the attribution requirement in Treas. Reg. Section 1.901-2. To satisfy that requirement, the tax must be (i) limited to gross income arising from sources within the foreign country, and (ii) determined by sourcing rules that are "reasonably similar" to the US sourcing rules (the source-based attribution requirement). For a foreign tax on royalty income, the 2022 Final Regulations require the tax to be sourced based on "the place of use of, or the right to use, the intangible property."
Because many jurisdictions source royalty income based on the residence of the payor, the source-based attribution requirement potentially rendered these jurisdictions' royalty withholding taxes non-creditable, even if the related intangible property was, in practice, actually used, or required by the license agreement to be used, in the source country.
The Proposed Regulations would add a new prong to the source-based attribution rule for royalties. Under the new rule, a foreign royalty withholding tax would meet the source-based attribution requirement if (i) the income subject to the tax is generally characterized as royalty income under the foreign tax law, and (ii) the terms of the license agreement under which the payment is made characterize the payment as a royalty and limit the territory of the license to the jurisdiction imposing the tax (the single-country rule). Even when the agreement does not limit the territory to the jurisdiction imposing the tax or provides for payments in addition to those for use of intangible property, a payment may still qualify for the rule if the portion of the payment that is subject to the tax is (i) separately stated in the agreement, (ii) characterized as a royalty under the agreement, and (iii) attributable to the jurisdiction imposing the tax. The single-country rule would not be available if the taxpayer knows, or has reason to know,1 that the agreement misstates the territory in which the intangible property is used or overstates the royalties for the withholding territory. The principles of IRC Sections 482 and 861 would apply to determine whether an agreement misstates the territory of use or overstates the royalties for that territory.
To be eligible for the single-country rule, a taxpayer would have to execute a compliant licensing agreement no later than the date of royalty payment (the documentation requirement). Under a special transition rule, royalties paid on or before May 17, 2023, would satisfy the documentation requirement if the licensing agreement were executed no later than May 17, 2023, and the agreement treated royalties paid on or before its execution as paid under the agreement.
The single-country rule in the Proposed Regulations represents a departure from the traditional "all-or-nothing approach" used to determine whether a foreign income tax is creditable. Under the all-or-nothing approach, a taxpayer's individual facts and circumstances are not taken into account in the analysis. In contrast, under the single-country rule, a particular jurisdiction's foreign withholding tax on royalties may be creditable for one taxpayer but not for another, depending on their individual contractual arrangements. This exception is expected to give taxpayers flexibility, enabling them to take some "self-help" measures to turn what is otherwise a non-creditable tax into a creditable one.
Companies with existing license agreements, particularly those companies whose agreements include intangible rights spanning territories, or that encompass both royalties and services, will need to carefully consider whether their licensing agreements should be modified to meet the requirements of the single-country rule. In those cases, an analysis should be undertaken to confirm the territory in which the intangible property is used under the principles of IRC Section 861 and the amount of the royalty under IRC Section 482. An example in the regulations suggests that failure to adhere to these principles, when a taxpayer knows or should have known how they should apply in its particular facts and circumstances, could completely preclude a license from qualifying under the single-country rule.
In many cases, the requisite changes to the licensing agreement should have no impact except for US tax purposes (i.e., the revisions to a license usually would not change the foreign tax owed, the amount of the royalty paid, or the territory covered, but would simply delineate which portion of the royalty relates to which territory). Nevertheless, companies may find it more difficult to meet the requirements in the Proposed Regulations if they need to negotiate with an unrelated counterparty.
Because the single-country rule will only apply to royalties paid before the revised licensing agreement's execution if the agreement is executed on or before May 17, 2023, taxpayers may need to start acting quickly. This is particularly important if revisions will require time-consuming negotiations with unrelated counterparties or will require complex analysis under the principles of IRC Sections 482 and 861.
Apart from the new single-country rule for withholding taxes on royalty income, the 2022 Final Regulations continue to take the all-or-nothing approach to analyzing foreign taxes, including service withholding taxes (which the Proposed Regulations do not address). The single-country rule's new case-by-case approach, if expanded to other areas in the regulation, could serve as a way to mitigate the cliff effect in which a foreign tax becomes non-creditable for all taxpayers due to a particular feature in the foreign tax law that may not be relevant to all taxpayers. Comments to the Proposed Regulations will likely request that this more fact-specific (and flexible) approach apply to other aspects of the regulation. Consideration could be given to applying a more flexible approach to the requirement to follow arm's-length principles in taxing resident entities, or to the rule basing sourcing of services on the place of performance, so that a foreign tax is not necessarily rendered entirely non-creditable for a particular taxpayer.
Allocation of foreign taxes in relation to disregarded sales of property
The 2022 Final Regulations include rules addressing the allocation and apportionment of foreign income taxes for, among other things, foreign tax credit purposes. Under these regulations, foreign income taxes are allocated and apportioned to statutory or residual groupings (including, for example, categories described in IRC Section 904(d)) based on the statutory or residual groupings to which a taxpayer's foreign income is assigned. To make this determination, a taxpayer must first assign its foreign gross income items to statutory or residual groupings. 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 to assign foreign gross income items to statutory or residual groupings, including foreign income items arising from payments that are disregarded for US federal income tax purposes (disregarded payments).
Different rules apply depending on whether the disregarded payment is a reattribution payment, a remittance, a contribution or a disregarded sale. Under the reattribution payment rule, a disregarded payment causes gross income to be reattributed 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. A payee taxable unit's foreign gross income from the reattribution payment is then assigned to categories based on the federal income tax characterization of one or more reattribution amounts that constitute the reattribution payment. For example, if a disregarded entity (DRE1) earned $100x of general category tested income and paid $30x in disregarded royalties income to another disregarded entity (DRE2) owned by the same taxpayer (CFC), the foreign gross income resulting from the disregarded payment, and the related taxes, would be allocated to CFC's tested income group in the general category. The result would be the same even if DRE2's regarded income was not tested income.
The remittance rule considers dividends and other disregarded payments treated as remittances as having been paid ratably out of all the accumulated after-tax income of the payor taxable unit. That after-tax income is deemed to arise in statutory and residual groupings in the same proportions that the tax book value of the taxable unit's assets are, or would be, assigned under the asset method of Treas. Reg. Section 1.861-9. In other words, the remittance rule uses the tax book value of the assets of the payor taxable unit to serve as a proxy for the character of the accumulated after-tax income from which the remittance is made. Frequently, however, the tax book value of a payor tested unit's assets is an unreliable proxy for accumulated after-tax income, because cash and other passive assets tend to have a basis equal to value, whereas operating assets are amortized, depreciated, or self-created, so their tax book value is zero. For example, a tested unit that earns solely tested income using fully depreciated tangible assets and self-created intangibles may be treated as having solely cash or deposit accounts (both, passive assets), so that a remittance from that entity would be assigned to the passive category.
For purposes of applying the remittance rule, reattributing income from one taxable unit to another reattributes the tax book value of the payor unit's assets that generated the reattributed income (reattribution assets). For example, assume a disregarded entity (DRE1) paid another disregarded entity (DRE2) owned by the same person (CFC) for services. As a result, a portion of DRE1's regarded income is reattributed under the reattribution payment rule from DRE1 to DRE2. Further assume that both DRE1 and DRE2 paid dividends (which constitute remittances) to CFC, in each case subject to a withholding tax. Under the reattribution asset rule, the portion of DRE1's assets corresponding to the reattributed gross income is reattributed from DRE1 to DRE2 for purposes of the remittance rule. Accordingly, that portion of the assets is not taken into account for purposes of characterizing the remittance (and related taxes) paid by DRE1 to CFC, but is taken into account for purposes of characterizing DRE2's remittance. The reattributed assets are called "reattribution assets."2
The Proposed Regulations would change the definition of reattribution assets. Specifically, the Proposed Regulations would exclude disregarded sales of property (including inventory property) from the set of reattribution payments that would give rise to reattribution assets. The Preamble describes the following example to illustrate an issue that the Proposed Regulations attempt to address. A domestic corporation directly owns two disregarded entities; DE1, which manufactures inventory property, and DE2, which purchases the inventory from DE1 and on-sells it to unrelated customers. The disregarded payment that DE1 receives from DE2 for the sale of inventory qualifies as a reattribution payment to the extent of DE2's regarded US gross income from its third-party sales; accordingly, a portion of DE2's assets is reattributed to DE1 as reattribution assets. The Preamble notes that the outcome "does not more accurately balance among the taxable units all of the assets that produced the gain from the inventory sale" because the reattribution asset rule only reattributes assets from DE2 to DE1. The Preamble then states that changes in the ratios of the assets considered held by the taxable units result in a greater portion of DE2's assets consisting of non-inventory assets, such as cash, and a greater portion of DE1's assets consisting of inventory.
Therefore, the Proposed Regulations would exclude any portion of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable unit for purposes of allocating and apportioning taxes upon a disregarded remittance.
The changes in the Proposed Regulations are limited and may affect taxpayers differently, depending on their particular asset profile. But the Proposed Regulations do not address the remittance rule's fundamental problem: apportioning foreign taxes based on the remitting entity's tax book value can be a poor surrogate for income or earnings. As a result, the remittance rule can cause taxpayers to lose the ability to credit a significant amount of foreign withholding taxes on remittances. The proposed regulations issued in 2020 acknowledged this concern with the tax-book-value method and requested comments on whether the rules should include a method that required "maintenance of historical accounts of accumulated earnings of taxable units, including adjustments to reflect disregarded payments among taxable units," in order to "produce more accurate results without unduly increasing administrative burdens" (see 85 Fed. Reg. 72078, 72086 (November 12, 2020)). This option, however, was not adopted in the 2022 Final Regulations. It appears that Treasury and the IRS may be open to revisiting this issue, as the Preamble to the Proposed Regulations 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 the meantime, taxpayers should carefully consider the extent to which the existing remittance rule affects their ability to claim foreign tax credits and what steps they can take to mitigate the issue. The Preamble also requests comments on whether other disregarded transactions should similarly be excluded from the reattribution asset definition — the types of transactions to which Treasury and IRS might expand the exception (without eliminating the reattribution asset concept entirely), however, are unclear.
The rules on the cost recovery and royalty attribution requirements would apply to foreign taxes paid in tax years ending on or after November 18, 2022, the date the Proposed Regulations were filed. Because the 2022 Final Regulations apply to foreign taxes paid in tax years beginning on or after December 28, 2021, the Proposed Regulations generally would apply to all tax years to which the 2022 Final Regulations would have otherwise applied, aside from short tax years that end before November 18, 2022. Taxpayers may choose to apply these rules, once finalized, for foreign taxes paid in earlier tax year(s) beginning on or after December 28, 2021 (this generally would only arise for short tax years), provided that taxpayers generally apply all the rules in Proposed Treasury Reg. Section 1.901-2 consistently.
The rules on disregarded payments would apply to tax years ending on or after the date that final regulations adopting these rules are filed. Taxpayers may choose to apply these rules, once finalized, for foreign taxes paid earlier in tax year(s) beginning after December 31, 2019, provided they apply the rules consistently and to all intervening tax years.
Taxpayers may rely on all or part of the Proposed Regulations, before they are finalized, for tax years beginning on or after December 28, 2021 (for the cost recovery and royalty attribution rules) or tax years beginning after December 31, 2019 (for the disregarded payment rules), provided the rules are applied consistently and by any related parties (within the meaning of IRC Section 267(b), but without regard to IRC Sections 267(c)(3) and 707(b)(1)).
While the Proposed Regulations would broaden the scope of creditable foreign taxes through the relief provided under the cost recovery rules and the sourced-based attribution rules for royalty income, they do not address, or provide safe harbors, for other situations in which traditionally creditable foreign taxes may be non-creditable under the 2022 Final Regulations. In particular, the Proposed Regulations do not change attribution rules that apply to:
Also unchanged are the realization requirement and the gross receipts requirement under the net gain requirement and the rules governing coordination with income tax treaties. Numerous comments to the Proposed Regulations requesting additional safe harbors and other relief are expected.
Numerous comments are also expected in response to the Proposed Regulations' request for comments on whether to change the disregarded payment rule (particularly in the context of the requirement to allocate remittances based on the tax book value of assets).
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor
1 The Proposed Regulations define "reason to know" broadly; as such, a taxpayer has reason to know that an agreement misstates the territory of use or overstates royalties if "a reasonably prudent person in the position of the taxpayer would question" whether the terms of the agreement misstate the territory in which the relevant intangible property is used or overstate the royalty.
2 As amended under the Technical Corrections, the reattribution rule governs a payment that arises from a disregarded sale of property and is a reattribution payment; to the extent that payment is not a reattribution payment, a special rule governing disregarded sales applies. Under that rule, income is assigned by reference to the grouping(s) to which built-in gain in the property would have been assigned if federal income tax law recognized the sale. For detailed discussions on this rule and its background and implications, see Tax Alert 2022-1179.