Proposed Foreign Tax Credit Regulations Reassure Taxpayers of Creditability of Certain Foreign Income Taxes

By: Jed Rogers, International Tax Partner; Julia Brent, Senior Tax Associate

At a glance

• The main takeaway: Recently released proposed foreign tax credit regulations (Proposed Regulations) provide helpful clarifications to the cost recovery and source-based attribution rules and generally make it easier to secure a foreign tax credit (FTC) with respect to a foreign income tax.
• Impact on taxpayers: Modification of the 2022 Final FTC Regulations (Final Regulations) by the Proposed Regulations should ensure less instances of double taxation.
• Next steps: Consult with an international tax specialist to conduct the appropriate FTC analysis. Aprio’s International Tax Team stands ready to help.

Schedule a consultation today

The full story:

The Final Regulations fundamentally modified and raised concerns among taxpayers that long-standing foreign income taxes may not be creditable. To summarize, the Final Regulations require satisfaction of a net gain requirement, which includes tests to establish realization, gross receipts, cost recovery and an attribution requirement. 

In a technical correction to the Final Regulations, the US Department of the Treasury addressed concerns about the perceived stringent nature of the cost recovery rules in the Final Regulations. In further response, the Proposed Regulations modify the Final Regulations as amended by the technical corrections. Notably, modifications in the Proposed Regulations to the cost recovery requirement should likely make it easier to determine whether foreign income taxes satisfy the requirement, and further, changes to the source-based attribution rule for royalties provide flexibility.

• Cost recovery requirement: As part of the Final Regulations, the cost recovery requirement required foreign tax law to allow recovery of all “significant costs and expenses” attributable to gross receipts in the foreign tax base. Costs and expenses for capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation were treated as “per se” significant costs and expenses. Any disallowance of a cost or expense would be allowed only if it was “consistent with the principles underlying the disallowances required under the Internal Revenue Code, including disallowances intended to limit base erosion or profit shifting.” As a result, there was confusion concerning whether a disallowance was consistent with the principles of the Internal Revenue Code, which was subsequently addressed by the technical corrections. Consistent with the technical corrections, the Proposed Regulations provide for a welcome clarification that foreign tax law need only allow for recovery of “substantially all” of each item of significant cost or expense, regardless of the disallowance principle. In addition, the Proposed Regulations provide for two safe harbors for purposes of applying the substantially all test:
  • permitting creditability where disallowances of significant costs and expenses do not exceed 25% of the cost or expense, or
  • where a foreign country caps recovery at not less than 15% of gross receipts, gross income or a “similar measure,” or not less than 30% of taxable income. 

Even if the substantially all test is failed, a foreign income tax should satisfy the cost recovery requirement if the disallowance is consistent with “any principles” of the Internal Revenue Code. Principles include base erosion, profit shifting and non-tax public policy concerns. Examples in the Proposed Regulations illustrate such an application, and in general, seem to indicate that a foreign disallowance only must be reasonably analogous to an income tax provision of an Internal Revenue Code principle. 

• Source-based attribution: The Final Regulations provided that a foreign withholding tax was creditable if the related gross income was sourced to the foreign country under sourcing rules reasonably similar to the Internal Revenue Code. In many cases, foreign countries do not source royalties based on the place or use or right to use intangible property (for instance, sourced based on the residence of the payor). Therefore, foreign withholding taxes incurred on such payment would no longer be creditable. As a result, the Proposed Regulations add another rule for the creditability of foreign withholding taxes incurred on royalties. The proposed “single-country rule” would allow an FTC if:
  • the income subject to withholding tax is characterized as a royalty under foreign law, and
  • there is a written license agreement stating plainly that the license territory is limited to the territory of the taxing jurisdiction. Even if the territory is not limited to the taxing jurisdiction, a royalty could still qualify if the relevant portion of the payment is separately stated and attributable to the taxing jurisdiction.  

Taxpayers must execute compliant license agreements no later than the date of the royalty payment. A transition rule provides that for royalties paid before May 17, 2023, the license agreement must be executed by that date and royalties paid prior to execution should be treated as paid under the agreement.

The bottom line

The Proposed Regulations are applicable once finalized to tax years ending on or after November 18, 2022 (i.e., 2022 for calendar-year taxpayers), but they can be applied and relied on retroactively to tax years beginning on or after December 28, 2021.

The Proposed Regulations help to broaden the scope of what foreign income taxes should qualify for a credit by meeting the cost recovery and source-based attribution rules. Taxpayers who would like to apply the single-country rule should assess compliance with their existing license agreements or execute new license agreements that carefully meet the requirements. This requirement is likely more difficult with respect to third-party license agreements because of required negotiation than those executed on an intercompany basis.  

Despite the helpful aspects of the Proposed Regulations, they do not remedy other issues concerning creditability as a result of the Final Regulations. For instance, issues of creditability of foreign income taxes should continue to arise with respect to:

1. withholding taxes imposed on nonresidents for services income (i.e., requires services income to be sourced based on the place of service performance),
2. taxes imposed on residents if income allocation under foreign law is not based on arm’s length principles and
3. taxes imposed on nonresidents for capital gains (i.e., taxes must be imposed on the nonresident’s activities in the jurisdiction or the situs of property).   

It is important to consult with an international tax specialist to review how you could be affected by these changes and conduct an appropriate FTC analysis. Schedule a consultation with Aprio’s International Tax Team today.