The final and proposed foreign tax credit regulations issued on Jan. 4, 2022, and Nov. 18, 2022, respectively, may cause many previously creditable foreign income taxes to become non-creditable for U.S. federal income tax purposes.
The provisions of the Final Regulations that relate to the creditability of foreign taxes apply to foreign taxes paid or accrued in taxable years beginning on or after Dec. 28, 2021.
HOW ARE TAXES AFFECTED BY THESE REGULATIONS?
Several categories of foreign taxes could be affected by the new provisions such as:
- Taxes paid directly by a branch operation
- Taxes paid through an entity that filed an entity classification election or a flow-through entity under local law
- Taxes paid via withholding on payments to the U.S. from another country
Deemed paid taxes, which are taxes paid by foreign subsidiaries of a U.S. corporation, may also be impacted.
Under these regulations, certain foreign taxes do not meet the new creditability requirements:
- Income taxes imposed by jurisdictions, which do not follow the U.S. transfer pricing
rules or the OECD arm’s length transfer pricing principles. For instance, Brazil does not currently follow the arm’s length principle. Brazil has introduced legislation to align with the OECD-based transfer pricing system to ensure U.S. corporations operating in its jurisdiction will continue to benefit from the creditability of Brazilian taxes in the U.S., but the legislation has not been enacted to date.
- Some foreign taxes offset by local tax credits (including refundable credits).
- Foreign taxes based on the location of customers or other destination-based taxes. For instance, digital service taxes introduced by European jurisdictions are not creditable. Digital-service taxes assert taxing jurisdiction based on a digital presence instead of a physical one, and the U.S. Treasury considered such taxes “diverge in significant respects from traditional norms of international taxing jurisdiction.”
- Royalty withholding taxes where the characterization or sourcing of the income under foreign law differs from that of the U.S. law. The U.S., unlike most countries, source royalty income based on where the intellectual property is used. Most countries source royalty income by reference to the country where customers are located. The new proposed regulations introduced a potential exception specifically for royalty income after it became apparent that the new requirement excluded a wide variety of royalty withholding taxes — see below to learn more about how royalties are affected.
- Income taxes that disallow recovery of certain significant expenses. “Significant” expenses are expenses that are generally recognized under U.S. law to reach net gain, such as wages and other operating expenses. The final regulations allow for some limitations if such limitations are consistent with the U.S. rules, like the interest expense limitation under U.S. tax law. The new proposed regulations have some safe harbors that, for example, gave a reprieve to the German trade tax. Other taxes such as Italian IRAP tax will need to be evaluated under the new proposed regulations.
The determination of whether a tax is creditable will be based on gathering information on foreign income taxes and withholding taxes by jurisdiction. The creditability of foreign taxes in each jurisdiction will then have to be evaluated to determine if the foreign tax conforms to the requirements of these final and proposed regulations. In addition, the analysis will require some additional research to understand how the tax is computed under local law.
Final regulations provided that a foreign levy treated as an income tax under an applicable U.S. income tax treaty qualifies as a “foreign income tax” if paid by a U.S. citizen or resident that elects benefits under the treaty. Controlled Foreign Corporations (CFCs) are not treated as U.S. residents under U.S. income tax treaties, therefore CFCs that are resident in a third country do not qualify for benefits under U.S. treaties.
HOW ARE ROYALTIES AFFECTED BY THESE REGULATIONS?
With respect to royalty payments, the new proposed regulations provide the single-country exception to the source-based attribution requirement. The limited exception was introduced after the Treasury and IRS received comments that certain withholding taxes would fail the new requirement even where the royalty payments would meet the U.S. rule (sourcing by reference to the country where the intellectual property is used) but such country assessed taxing jurisdiction by reference to the location of customers under local law.
To qualify for this limited exception, a taxpayer must have proper documentation in place in the form of a written license agreement. The single-country exception applies where both:
- The income subject to the tested foreign tax is characterized as gross royalty income
- The payment giving rise to such income is made pursuant to a single-country license
Taxpayers will need to determine whether the license agreements currently in place fall within the single-country license exception. Taxpayers will have to determine that royalties are paid and to specifically determine which agreement covers the specific payments. There is a transitory rule for taxpayers to update their license agreements. Royalties paid on or before May 17, 2023, satisfy the documentation requirement if the license agreement is executed no later than May 17, 2023.
Royalties generally may fall into several categories:
- Royalties that are received from countries that either do not impose withholding tax or have a U.S. treaty that reduces the withholding tax on royalties to zero. This is of course the best scenario and there are no foreign tax credit issues.
- Royalties that are received from countries that have a treaty with the U.S. but do not reduce the withholding tax to zero. As mentioned above, the final regulations contain a treaty coordination rule under that a credit is provided for taxes treated as covered taxes under the relief from double taxation article of a U.S. tax treaty and paid by a U.S. resident that elects benefits under that treaty. If this requirement is met any withholding taxes on royalties should be eligible for foreign tax credit purposes.
- Royalties that are received from a non-treaty country that has withholding, and the license is for use only in that country. The special exception in the proposed regulations specifies that a single-country license withholding tax on royalties is creditable for U.S. foreign tax credit purposes even if the payor country sources the income to the country of the payor rather than sources it to where it is used (which is the general requirement).
- Royalties that are received from a non-treaty country that has withholding tax and the license covers a geographic area beyond the country of the payor or is a worldwide license. Withholding tax on such royalties are NOT creditable for U.S. foreign tax credit purposes even if the actual use is in the single country where the payor is located. This area requires planning that may include revising the license agreements to a single country where possible, allocation of the license payments to the country of the payor and the rest of the territory as well as other options.
Please contact GHJ’s International Tax Services Team for a more comprehensive discussion of the tax implications of the final and proposed regulations on foreign tax credits and related tax planning considerations.