On November 18, 2022, proposed regulations (Proposed Regulations) were released by the U.S. Department of the Treasury (Treasury) related to the foreign tax credit (FTC) in response to final regulations published on January 4, 2022, as amended by technical corrections published on July 27, 2022 (the Final Regulations). As noted in the preamble of the Final Regulations, Treasury provided for revisions designed to ensure that a foreign tax is a creditable net income tax only if the determination of the foreign tax base conforms in material aspects to the determination of taxable income under the Internal Revenue Code (Code). The Proposed Regulations clarify the definition of a reattribution asset for purposes of allocating and apportioning foreign income taxes by statutory grouping and modify certain provisions in the Final Regulations regarding creditability of a foreign income tax, mainly with respect to (1) the application of the cost recovery requirement to the net-gain rule and (2) the application of the source-based attribution requirement to withholding taxes on certain royalty payments. The applicability dates of the provisions included in the Proposed Regulations vary but would generally allow taxpayers to apply the Proposed Regulations to all foreign income taxes subject to the date of the Final Regulations.
Definition of Reattribution Asset for Foreign Income Tax Allocation & Apportionment
For purposes of allocating and apportioning foreign income taxes, the Proposed Regulations retain the general definition of a “reattribution asset” as codified in the Final Regulations but exclude any portion of the tax book value of property transferred in a disregarded sale from being attributed back to a selling taxable unit. The Final Regulations provided rules for allocating and apportioning foreign income tax arising from a disregarded payment due to the fact foreign gross income included by reason of receipt of a disregarded payment will generally have no corresponding U.S. item since U.S. federal income tax law does not regard otherwise disregarded payments. As noted in the Final Regulations, foreign gross income included by reason of a remittance is assigned to the statutory and residual groupings by reference to the proportion of the tax book value of the assets of the remitting taxable unit in the groupings as assigned for purposes of apportioning interest expense and other items that interplay with the allocation and apportionment of foreign income taxes. The Final Regulations considered a reattribution asset rule in the context of a payor taxable unit (payor) making a disregarded payment to a recipient taxable unit (recipient). Under this reattribution asset rule, a reattribution of income from one taxable unit (payor) to another taxable unit (recipient) is required to result in an associated reattribution of the tax book value of the assets of the payor that generated the reattributed income (reattribution assets) from the payor to the recipient. In updating the definition of a reattribution asset, Treasury notes in the preamble that the reattribution rule is no longer needed for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, and particularly with respect to disregarded sales of inventory property mainly because of a perceived imbalance in tax book value ratios between distributor and manufacturing taxable units where manufacturing units generally carried a disproportionate share of inventory assets in their tax book value ratio relative to a distributor unit. This revision to the definition of “reattribution asset” should result in less disparity between asset apportionment ratios and likely better aligns the asset apportionment ratios with the economic circumstances of certain affected taxpayers.
Cost Recovery Standard Revisions
The Proposed Regulations generally broaden the cost recovery standard under the net-gain requirement to provide for “substantially all” of each item of significant cost and expense when analyzing whether the relevant foreign tax law base aligns with the U.S. federal income tax laws and creates new safe harbor provisions for certain deduction limitation adjustments under foreign law when applying the principles-based exception to the cost recovery standard. The Final Regulations for the FTC intended to revise the net-gain requirement to better align the regulatory tests with principles in the Code for determining the base of a U.S. income tax when assessing the creditability of a foreign income tax. In so doing, the Final Regulations replaced the former net income requirement with the cost recovery requirement. Under the cost recovery requirement, the base of a foreign tax requires the recovery of significant costs and expenses attributable to gross receipts included in a taxpayer’s foreign tax base. Determination of whether costs and expenses are significant is required to be performed under an empirical analysis based on whether—for all taxpayers in the aggregate to which the foreign tax applies—the item of cost or expense constitutes a significant portion of the taxpayers’ total costs and expenses. The provisions of the Final Regulations relating to the cost recovery standard further recognized that foreign countries limit the recovery of certain significant costs and expenses similar to certain provisions in the Code. Thus, the Final Regulations included a “principles-based exception” to the cost-recovery standard that states that foreign tax law is considered to permit the recovery of significant costs and expenses, even if recovery of certain significant costs and expenses is disallowed in whole or in part, if such disallowance is consistent with any principle underlying the disallowances required under the Code. Following the release of the Final Regulations, this principles-based exception received multiple comments noting that numerous foreign tax laws impose disallowances and other limitations on the recovery of costs and expenses that are not clearly matched to a principle underlying a similar disallowance of the Code despite other aspects aligning with a net income tax from a U.S. tax perspective. Furthermore, other comments noted that performing any empirical analysis regarding certain foreign countries’ tax laws would prove to be an impractical exercise due to a lack of information from certain foreign countries.
In response to taxpayer comments, the Proposed Regulations generally retain the cost recovery standard under the Final Regulations but provide that the relevant foreign tax law need only permit recovery of “substantially all” of each item of significant cost and expense. In so doing, Treasury further notes that complete conformity between the rules for determining the foreign tax base and the U.S. tax base is not a requirement. Addressing further concerns with the principles-based exception, the Proposed Regulations provide a new safe harbor with respect to foreign tax law limitations on the ability to recover certain costs and expenses related to the foreign tax base. Under the safe harbor, a disallowance of a stated portion of items of significant cost and expense does not prevent the foreign tax in question from satisfying the cost recovery requirement so long as the portion of the items that are disallowed do not exceed 25% of the total cost or expense prior to application of any disallowance provision. The safe harbor provision also permits the relevant foreign tax law to cap deductions of a single item or multiple items of per se significant costs described in the Final Regulations as long as the cap is not less than 15% of gross receipts, gross income, or similar criteria applied under foreign tax law principles. An additional safe harbor provision for a “qualified cap” is included in the Proposed Regulations in the case of caps based on a percentage of foreign taxable income. Under this qualified cap safe harbor provision, a cap on taxable income would not prevent an item from qualifying under the cost recovery standard if the cap is not less than 30% of foreign taxable income when applying principles of the foreign country’s tax laws. The safe harbor provisions in the Proposed Regulations provide for flexibility for taxpayers applying the cost recovery standard since compliance would generally mean that taxpayers need not consider the reason for the foreign tax law deduction disallowance under the principles-based exception. Notwithstanding this generally taxpayer-friendly addition, if the foreign tax law disallowance fails the safe harbors, the principles-based exception under the Final Regulations would still be applicable to taxpayers and may be the means for redress in determining whether the cost recovery standard is met.
New Single Country Exception to Source-Based Attribution for Certain Royalty Payments
The Proposed Regulations provide a new “single country exception” to the source-based attribution requirement adopted in the Final Regulations when analyzing whether a foreign tax on a royalty is a covered withholding tax and adopt conforming language in the source-based attribution requirement for royalties to clarify consistent application of the source-based attribution test for royalties and service payments. As a means to allow taxpayers to credit foreign taxes only if the foreign country has sufficient nexus to such taxpayer’s activities that generate income in the foreign tax base, the Final Regulations added an attribution requirement to the net-gain rule designed to ensure that a foreign tax base aligns to the concepts of taxing jurisdiction as reflected in the U.S. under the Code. With respect to foreign withholding taxes imposed on nonresident taxpayers, the attribution requirement under the Final Regulations generally limits the scope of gross income and expenses included in the base of a foreign tax to those that satisfy one of three attribution tests, i.e., activities, source, and property. Under the source-based attribution test, a foreign tax imposed on a nonresident’s income on the basis of source meets the attribution standard only if the foreign tax law’s sourcing rules are reasonably similar to the applicable sourcing rules in the Code, which in the case of royalties requires that foreign tax law must source royalties based on the place of use or right of use with respect to the intellectual property. Thus, under the Final Regulations, a withholding tax imposed on royalties that are imposed on the basis of the residence of the payor is not creditable regardless of whether the relevant intellectual property is in fact used within the territory of the taxing jurisdiction.
Addressing numerous taxpayer complaints regarding the source-based attribution test with respect to royalties, the Proposed Regulations provide for the single country exception, a limited exception to the source-based attribution test where a taxpayer can substantiate that a withholding tax is imposed on royalties received in exchange for the right to use intellectual property solely within the territory of the taxing jurisdiction. Moreover, to further integrate the new single country exception into the source-based attribution rule, the Proposed Regulations modify the separate levy rule to include as a levy certain withholding taxes imposed on nonresidents under the new single country exception. To satisfy this exception, the Proposed Regulations provide for a substantiation requirement that would require taxpayers must have a written license agreement in place at the time the royalty is paid that specifies the payment of the royalty and the limited use of the intellectual property attributable to the royalty in the foreign country imposing the tax. In so doing, Treasury would generally require taxpayers to trace the amount of a royalty attributable to use in the taxing jurisdiction.
Finally, during the comment period of the Final Regulations, many taxpayers questioned whether the sourcing rule for royalties as applied under the source-based attribution test was to be applied differently in the context of service payments due to ambiguous language included in the Final Regulations. Addressing taxpayer concerns in the Proposed Regulations, Treasury clarifies that the applicability of the source-based attribution test with respect to royalties and service payments is held to the same standard by adding conforming language to the provision for royalties that is included in the language regarding source-based attribution for services in the Final Regulations.
Overall, the Proposed Regulations appear to address key concerns with the Final Regulations raised by taxpayers. For one, the safe harbor tests included in the Proposed Regulations provide for more flexibility on the FTC regime of the U.S. than the Final Regulations with respect to accounting for differences between foreign country income tax laws when applying the cost recovery standard to the net-gain rule. Taxpayers should consult with their tax advisors to understand how the safe harbors provided in the Proposed Regulations may affect their current and future FTC posture. In addition, the single country exception for the application of source-based attribution with respect to royalties generally trends in the right direction for taxpayers that would otherwise lose FTCs associated with royalty payments solely due to differences in sourcing rules between the U.S. and a taxing jurisdiction that sources royalties based on the residence of the payor. Despite the single country exception generally trending in the right direction, taxpayers may find that the substantiation requirement for the single country exception will require additional burden with respect to licensing agreements already in place. If not already articulated in pre-existing agreement, adopting the substantiation requirements included in the single country exception likely means that taxpayers may need to renegotiate terms in their licensing agreements to be more specific and may find administrative burdens in specifying the limited use of the intellectual property in question. Thus, taxpayers affected by the source-based attribution requirement with respect to royalties that are seeking to apply the single country exception should consider reviewing their licensing agreements with their tax advisors to ensure they comply with the single country exception substantiation requirements included in the Proposed Regulations.
While most of the changes included in the Proposed Regulations appear to be mainly taxpayer favorable in the sense that some of the stringent requirements of the Final Regulations would now be relaxed, Treasury still appears to have dismissed other taxpayer calls for an outright repeal of the Final Regulations and continues to remain silent on how the source-based attribution requirement would more equitably apply in the context of certain foreign withholding taxes that were once creditable under the old net income rules, e.g., foreign withholding taxes on services performed in Latin American countries with no U.S. income tax treaty in place. As a result, without further guidance or clarification from Treasury, it would appear that these foreign withholding taxes would no longer be creditable under either the Final Regulations or Proposed Regulations as a foreign income tax for purposes of claiming the FTC. Taxpayers should strongly consider assessing their global income tax exposure and evaluate whether their foreign taxes paid qualify as a creditable foreign income tax for purposes of the FTC.
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