On Nov. 18, 2022, the Treasury Department published proposed regulations (REG-112096-22) amending the final foreign tax credit (FTC) regulations published on Jan. 4, 2022 (TD 9959; amended by technical corrections published July 27, 2022).
Historically, US taxpayers have been allowed to use FTCs from foreign income taxes paid to a foreign jurisdiction to offset their foreign-source income subject to certain limitations. Foreign income taxes aren’t the only creditable taxes, but foreign taxes paid “in lieu of a tax on income” are also included in this category.
As expected, a series of regulations has been issued by the Treasury and the Service to address the question of what conditions a foreign tax should satisfy to be considered a tax imposed on income from a US federal tax perspective. Before the 2022 final regulations were enacted, one of the tests applied to a foreign tax to determine its creditability in the US was known as the "net income” requirement. This test used to be satisfied if the foreign tax was imposed only on income remaining after recovery of expenses (i.e., foreign tax base equivalent to net income).
The 2022 final FTC regulations, however, adopted a “cost recovery” requirement as a substitute for the net income requirement. This new approach requires the gross receipts to be reduced by significant costs and expenses attributable, under “reasonable principles,” to such gross receipts in order to compute the tax base of the foreign tax. For purposes of this test, interest, rents, capital expenditures or other service fees are considered “significant costs and expenses.”
While the 2022 final regulations offered an alternative for a foreign tax law to satisfy the cost recovery requirement even if the recovery of significant costs and expenses wasn’t allowed, the conditions to benefit from this alternative are considered somehow too strict, preventing US shareholders from obtaining FTCs with respect to several foreign taxes.
Under the new proposed regulations, the cost recovery requirement is intended to be relaxed by providing that a foreign tax law would satisfy this test to the extent it allows the recovery of "substantially all" of each item of significant cost or expense, without regard to the underlying principles used to grant any disallowances.
The flexibility of the new “substantially all” subtest is also complemented by two safe harbors that will ease the application of the cost recovery test. Under the proposed regulations, a foreign tax doesn’t fail the "substantially all" test if the underlying foreign tax law disallows no more than 25% of one or multiple cost items.
Additionally, the test also will be satisfied if the recovery of a single item of significant cost or expense or multiple items within a single category of per se significant costs or expenses are limited by the underlying foreign tax law based on a "qualifying cap." For purposes of this second safe harbor, a qualifying cap means any foreign tax law that caps cost recovery based on no less than 15% of gross receipts, gross income or a "similar measure," including a foreign tax law that caps cost recovery based on no less than 30% of taxable income.
The proposed regulations also impact the “attribution” requirement added by the 2022 final FTC regulations. In general, the attribution test works as the jurisdictional nexus requirement that a foreign tax should meet in order to be creditable in the US. To clarify the sourcing of royalties derived from certain licensing agreements, the proposed regulations provide that a taxpayer would satisfy this nexus requirement if the licensing agreement expressly limits the use of intangible property to the country imposing the tax (the single-country rule).
Nevertheless, the requirement wouldn’t be satisfied if the taxpayer knows, or has reason to know, that the licensing agreement overstates the royalties or misstates the jurisdiction in which the intangible property is intended to be used.
In terms of applicability dates, these new rules on the cost recovery and attribution requirements would apply to foreign taxes paid in tax years ending on or after Nov. 18, 2022.
Finally, the proposed regulations also revise several rules on disregarded payments pursuant to Treas. Reg. Section 1.861-20, clarifying that disregarded payments received in exchange for property shouldn’t be treated as “reattribution assets” when allocating taxes upon a disregarded remittance. The rules would apply to tax years ending on or after the date the regulations are finalized.
In general, these proposed regulations represent a fair relief expected by taxpayers with operations overseas. After the technical corrections were published July 27, 2022, as a response to comments from the tax community to the 2022 final regulations regarding the impossibility of crediting foreign taxes that had historically been creditable, there were still essential rules that weren’t addressed by the technical correction.
While these proposed regulations don’t answer all the issues derived from the 2022 final regulations and ignored by the technical correction, they do confirm to taxpayers that certain foreign taxes they used to credit in the US prior to the 2022 final regulations are still eligible for FTCs under current tax law.
Please contact your Mazars professional for additional information.
Author: Juan Fernandez
The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.