Final FTC Regulations: Significant Changes to the Creditability of Foreign Income Taxes

By: Jed Rogers; Tamara Fusillo

At a glance

• The main takeaway: Foreign tax credit (FTC) final regulations have made it more difficult to determine whether FTCs are available for foreign taxes incurred by U.S. taxpayers.
• Impact on taxpayers: Various new requirements (such as the attribution requirement noted below) may cause double taxation of income.  Many common and previously creditable foreign taxes may no longer be creditable.
• Next steps: Consult with an international tax specialist to conduct the appropriate FTC analysis.  Aprio’s International Tax Team stands ready to help.

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The full story:

The final regulations on foreign tax credits fundamentally modify the rules for determining the creditability of foreign tax.  For creditability, a foreign income tax must satisfy the net gain requirement, which includes tests to establish realization, gross receipts, and cost recovery.  Further, the net gain requirement now incorporates an “attribution requirement” that must be satisfied.  The attribution requirement is satisfied by a nonresident of the taxing country (i.e., a U.S. taxpayer or a controlled foreign corporation (CFC) of a U.S. taxpayer) if one of the following tests is met:

• Activities test: A foreign tax imposed based on nonresidents’ activities must be limited to the gross receipts and costs that are attributable, under reasonable principles, to nonresidents’ activities within the foreign country imposing the tax (including functions, assets, and risks).  It does not include the location of customers, users, or similar destination-based criteria or the location of persons from whom the nonresident makes purchases.  They also exclude foreign rules that deem a permanent establishment or attribute gross receipts, or costs based on the activities of a person other than the nonresident (besides an agent).
• Source test: To satisfy the source test, the foreign tax must be imposed based on a sourcing rule that is reasonably similar to the US rule.  When evaluating whether a foreign law sourcing rule is reasonably similar, the character of an item of gross income generally is determined under foreign law.  For example, if a payment would be characterized as services income under U.S. principles, but as a royalty under foreign law, the foreign law source rule for royalties must be reasonably similar to the US source rule for royalties.  For services income, the payment source must be determined based on where the services are performed.   Therefore, a withholding tax imposed on payments for services performed in the country imposing the tax would meet the test.  For royalties, the source of the payment must be determined based on the place of use of, or the right to use, the licensed intangible property.   Consequently, for instance, an FTC would not be available if a foreign jurisdiction imposes a withholding tax on royalties under a rule based on the residence of the payment recipient.  However, the U.S. Treasury has indicated additional changes will be forthcoming to address potential relief for certain royalty withholding taxes.  In the case of a sale of property, including sales of copyrighted articles (e.g., software sales), the source test is unavailable, and the attribution requirement can only be met under the activities or situs test.
• Situs test: To satisfy the situs test, a foreign tax based on gains of nonresidents from the sale or disposition of property must be attributable to gross receipts from the disposition of real property located in a foreign country, or an interest in a resident entity that owns the real property, under rules reasonably similar to the U.S. Foreign Investment in Real Property Tax Act (FIRPTA) rules.

Nevertheless, if a foreign tax does not satisfy the attribution requirement, it may still qualify as a creditable income tax under a treaty exception.  If the foreign tax is imposed on a U.S. taxpayer, it can qualify as a creditable income tax, if the tax is treated as an income tax under a U.S. tax treaty, and the U.S. taxpayer elects benefits under the treaty.  In the case of a foreign tax incurred by a CFC, because a CFC is not a U.S. taxpayer, the foreign tax must independently satisfy qualification of a foreign income tax, but certain modifications under the foreign treaty may be considered.

The final regulations also tightened the aforementioned cost recovery requirement.  In general, a foreign tax satisfied the cost recovery requirement only if the foreign tax allowed for the recovery of all “significant costs and expenses.”  Exceptions were possible, but only if a disallowed expense deduction was “consistent with the principles underlying the disallowances” under US tax law.  In a technical correction to the final regulations recently released on July 26, the Treasury addressed concerns about the perceived stringent nature of the cost recovery rules in the final regulations.  The technical correction broadens the intended reading of the rule, and in part, the regulation language was changed to “including capital expenditures,” remov the word “significant,” and refer to “any principles” rather than “the principles.” 

While the effective dates in the final regulations may vary by provision, generally many provisions are effective for tax years beginning on or after December 28, 2021 (i.e., 2022 for calendar-year taxpayers). 

The bottom line

Due to the final regulations, taxpayers could find that traditionally creditable taxes may be denied and face the prospect of double taxation on income.  The scope of the regulations is far broader than denying a foreign tax credit for digital services taxes.  Consequently, taxpayers should carefully consider the new requirements, in particular the attribution requirement, because withholding taxes on royalties and service may not be creditable now. 

It’s important to consult with an international tax specialist to review how you could be affected by these changes and conduct an appropriate FTC analysis.

Contact Aprio’s International Tax Team for help.

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