Treasury releases Notice of Proposed Rulemaking providing additional Foreign Tax Credit guidance and limited relief
On November 18, 2022, the IRS and Treasury released a notice of proposed rulemaking (the Notice) relating to certain provisions of the US foreign tax credit (the Proposed Regulations) rules.
The Proposed Regulations were issued in part in response to concerns and reservations expressed by taxpayers following the earlier issuance of final foreign tax credit regulations in TD 9959, published in the Federal Register on January 4, 2022 (the 2022 Final Regulations).
The interpretation of certain aspects of the 2022 Final Regulations, especially as it relates to the cost recovery and attribution requirements, has proven to be challenging to taxpayers and their advisors, resulting in uncertainty and some confusion as to the creditability of certain foreign taxes. The Proposed Regulations provide anticipated and generally helpful guidance on the application of the reattribution asset rule for purposes of allocating and apportioning foreign taxes, the cost recovery requirement, and the modest relaxation of the attribution rule for withholding taxes on royalty payments.
Reattribution asset rules
The 2022 Final Regulations provided specific guidance with respect to the allocation and apportioning of foreign taxes in the context of disregarded transactions. Certain disregarded payments are treated under those rules as “remittances” and foreign taxes related to foreign gross income included by reason of a remittance is assigned by reference to the proportion of the tax book value (TBV) of the assets of the remitting taxable unit. For purposes of determining such TBV, the Final Regulations include a “reattribution asset rule” which generally requires a reattribution of the TBV of assets from the payor taxable to the recipient taxable unit with respect to property that generates reattributed income.
The Treasury Department and the IRS have concluded that the reattribution asset rule is not needed for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, particularly with respect to disregarded sales of inventory. Accordingly, the Proposed Regulations generally retain the definition of “reattribution asset” but modify it to exclude any portion of the TBV of property transferred in a disregarded sale. Therefore, under the Proposed Regulations, the value of such asset will not be reattributed to the selling taxable unit.
The Proposed Regulation relating to the Reattribution Asset Rule applies to taxable years ending on or after the date the Proposed Regulations are finalized, although taxpayers may choose to apply the Proposed Regulations to taxable years beginning after December 31, 2019, provided they meet certain consistency requirements.
Credibility of foreign taxes – changes to the cost recovery requirement
Section 901 generally permits a taxpayer to claim a credit for "income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or possession of the United States.” The 2022 Final Regulations significantly modified the requirements that a foreign levy must satisfy to be treated as a creditable income tax. While the 2022 Final Regulations retained its historic requirements, they added additional conditions to satisfy a cost recovery requirement, and a new attribution requirement was added. The cost recovery requirement has created uncertainty for many taxpayers.
The cost recovery requirement is satisfied only if, under reasonable principles, a foreign tax law (i) allows for the recovery of significant costs and expenses attributable to gross receipts in the foreign tax base under or (ii) permits recovery of an alternative that by its terms may be greater, but never less, than the actual amounts of significant costs and expenses.
The 2022 Final Regulations deem certain costs to be significant costs that must be recoverable in all cases to satisfy the cost recovery requirement: capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation. The 2022 Final Regulations permit the disallowance of all or a portion of certain costs or expenses so long as such disallowance is consistent with "any principle underlying the disallowances required under the [Code]," including "the principles limiting base erosion or profit shifting and public policy concerns." Despite this additional guidance, the assessment of whether the cost recovery requirement is satisfied has remained challenging for taxpayers. The Treasury and IRS acknowledged this difficulty in the Notice of Proposed Rulemaking and provided taxpayers with some relief when assessing the cost recovery in issuing in the latest Proposed Regulations.
The Proposed Regulations state that the “IRS and Treasury recognize that in certain instances, the cost recovery requirement should be satisfied even if a foreign tax law contains a disallowance or other limitation on the recovery of a particular cost or expense that may not be specifically reflected under U.S. federal income tax principles.” This statement indicates that complete conformity between the rules for determining the foreign tax base and the US tax base is not required to satisfy the cost recovery requirement.
Most importantly, the Proposed Regulations provide a safe harbor for purposes of applying the cost recovery requirement. Under the safe harbor, a disallowance of a stated portion of an item, or items, of significant expense does not prevent a foreign tax from satisfying the cost recovery requirement if the portion of the item, or items, disallowed does not exceed 25 percent. Additionally, the safe harbor permits foreign tax law to cap deductions of an item or items of significant expense that relate to a single category of enumerated significant costs and expenses. However, the cap, under the terms of the foreign law, must not be less than 15 percent of gross receipts, gross income, or in the case of a cap based on a percentage of taxable income, the cap is not less than 30 percent.
The safe harbor eliminates the need for a taxpayer to provide reference to a US tax law principle that mirrors the foreign principle being considered and arguably provides a more consistent and clearer set of guidelines as to what expense disallowances will not be so significant as to cause the foreign tax to meet the cost recovery test.
The Proposed Regulations would apply to foreign taxes paid in taxable years ending on or after November 18, 2022. However, taxpayers may choose to apply the rules of Proposed Regulations, once finalized, for foreign taxes paid in taxable years beginning on or after December 28, 2021, and ending before November 18, 2022, provided that they consistently apply those rules to such taxable years.
Attribution requirement for royalty payments
As mentioned above, the 2022 Final Regulations added an attribution requirement that provides separate rules to determine whether a foreign tax is creditable based on whether the tax is imposed on residents or nonresidents of the jurisdiction imposing the tax. Generally, for a tax on nonresidents to be creditable, it must meet one of three attribution requirements: activities-based nexus, source-based nexus, or property-based nexus. The attribution requirement has proven to be burdensome for taxpayers in the context of withholding tax on royalties.
Under the attribution requirement applicable to nonresidents in the jurisdiction imposing a foreign tax, the sourcing rules of a foreign country must be “reasonably similar” to the sourcing rules that apply for US federal income tax purposes. In the case of gross income arising from royalties, the 2022 Final Regulations provide that the foreign tax law must source royalties based on the place of use or the right to use the intangible property.
The Proposed Regulations introduce a limited exception to this rule as it relates to royalties, which provides that where the payment giving rise to such income is made pursuant to a single-country license, then any withholding tax on royalty payments under such license is creditable for US federal income tax purposes (the single country exception). The single country exception is only applicable if the taxpayer has a written license agreement that provides for the payment of the royalty and that agreement by its terms limits the use of the intangible property giving rise to the royalty to the territory of the foreign country imposing the tax. The agreement may contain broader provisions, including being related to services in addition to a license of intangibles or not limiting the license to the jurisdiction imposing the tax; to the extent that the agreement separately states the portion of the payment that relates to royalties and that is with respect to the jurisdiction imposing the tax, the taxpayer can satisfy the conditions of the single country exception.
A special transition documentation rule is provided for royalties paid on or before May 17, 2023. In that case, to satisfy the documentation requirement, the required agreement must be executed no later than May 17, 2023, and the agreement must state (whether in the terms of the agreement or in recitals) that royalties paid on or before the execution of the agreement are considered paid pursuant to the terms of the agreement.
The single country exception, while narrow, provides certainty for taxpayers licensing intellectual property. To the extent that taxpayers currently have multiple-country foreign use licenses of intellectual property in place, taxpayers should consider dividing the rights of such licenses into single-country licenses to comport with the single country exception. This may prove more challenging in cases where unrelated parties are involved.
Taxpayers may choose to apply the rules, once finalized, for foreign taxes paid in taxable years beginning on or after December 28, 2021 and ending before a date to be determined in the finalized regulations, provided that they consistently apply those rules to such taxable years. The applicability date of the Proposed Regulations aligns directly with the applicability date of the 2022 Final Regulations, allowing taxpayers to apply these modified rules to the same period.
The changes contained in the Proposed Regulations provide some relief to taxpayers. However, these changes are nuanced and should be analyzed carefully by taxpayers.
Learn more about the implications of this development by contacting any of the authors or your usual DLA Piper relationship attorney.