On January 4, 2022, the Internal Revenue Service (IRS) and the U.S. Treasury Department (the Treasury) issued final regulations (Regulations) that provided significant guidance on the determination of whether a foreign tax is eligible for the U.S. foreign tax credit (FTC).1 These Regulations substantially modify prior regulations issued under Internal Revenue Code (Code) sections 901-905.2 The Regulations can preclude certain foreign withholding taxes and other taxes that have historically been considered creditable from being claimed as a FTC. These Regulations apply to foreign taxes paid in tax years beginning on or after December 28, 2021.
The Regulations add a new requirement (Attribution Requirement) that must be met for a foreign tax to be creditable. The Attribution Requirement requires U.S. taxpayers to have knowledge of foreign law on how a transaction should be characterized and how income is sourced from that transaction under foreign law. It also requires the taxpayer to make a subjective analysis of whether the foreign law is “similar to” the Code, or whether the foreign law “is reasonable.” Thus, the Regulations not only increase the complexity of foreign tax credits in general, but also the cost and time to determine if a foreign tax is creditable.
A foreign tax satisfies the Attribution Requirement if the gross receipts and costs included in the foreign tax base are based on one of three requirements for (1) activities, (2) source, or (3) situs of property.
Activities. Attribution based on activities refers to the gross receipts and costs that are attributable “under reasonable principles” to the nonresident’s activities within the foreign country imposing the tax. Reasonable principles include attribution based on a nonresident’s functions, assets and risk located in the foreign country similar to determining effectively connected income (ECI) under Code Sec. 864(c). Specifically excluded from this attribute test are locations of customers and users, similar destination-based criteria, or the location of a supplier.
Source. Attribution based on source refers to gross income arising from sources within the foreign country. Under this requirement, the sourcing rules must be reasonably similar to the source rules of the Code. To make this determination, the character of the gross income is generally determined using foreign law. For services, the payment source under foreign law must be determined based on where services are performed. Place of performance does not consider the location of the service recipient, except when that is where the services are performed. For royalties, the source of payment must be determine based on place of use or the right to use, not residency of person making the payment. For example, if the transaction is sourced as a service for U.S. tax purposes, but sourced as a royalty for foreign tax purposes, the transaction will be sourced as royalties for purposes of determining if the tax is creditable.
Situs of property. Attribution based on situs refers to situations in which U.S. federal tax law would tax a nonresident’s capital gains. For a tax imposed on property other than real property, the base may only include gross receipts attributable to property forming part of the business property of a taxable presence under rules similar to 864(c) or ECI.
Thus, to determine if a particular foreign tax will be a creditable FTC, a U.S. taxpayer will have to (i) determine the character of the transaction (i.e., income from the sale of property, royalty income, rental income or service income) under the Code; (ii) determine the source of the income (i.e., U.S. or foreign) under the Code; (iii) determine the character of the transaction under foreign law; and (iv) determine if the tax is a creditable under section 901 or section 903 by applying the tests described under each Code section. The complexity of the Regulations will require all taxpayers, but in particular, small to mid-size taxpayers, to spend additional time and resources to determine if an FTC is available for foreign taxes paid, or may force taxpayers to forego a valuable tax credit. Either alternative is a costly decision.
The Regulations are effective in 2022. For international tax assistance or questions regarding specific risks and opportunities to your international business strategies, please contact your Cherry Bekaert advisor or a member of the International Tax Services practice.
References
1 T.D. 9959, 87 Fed. Reg. 276 (Jan. 4, 2022).
2 All section references are to the Internal Revenue Code, as amended (the “Code”), or related Treasury regulations, unless otherwise indicated.
