Our International Tax Group examines the attribution requirement (born jurisdictional nexus requirement) of the Foreign Tax Credit Final Rule and finds that taxpayers will still face uncertainties in the application of the Foreign Tax Credit .
- IRS Seeks to Modernize Regulations to Ease Double Taxation of Foreign Source Income
- Many of the final regulations follow the proposed regulations, but some have been modified based on taxpayer feedback
- Gray areas remain, including how reasonably similar a foreign rule should be
On December 28, 2021, the Treasury Department and the IRS released another installment of the final Foreign Tax Credit (FTC) rule, which was officially published in the Federal Register on January 4, 2022. The final rule takes effect on March 7, 2022 and generally applies to tax years, or foreign income taxes paid or accrued in tax years, beginning on December 28, 2021 .
The final settlement is by no means light reading, spanning 101 pages in the Federal Register. For the purposes of this notice, we focus only on the attribution requirement, one of the most controversial provisions of the final settlement. It should be noted that, among other things, the final regulations relate to the denial of a foreign income tax credit or deduction on dividends eligible for a deduction for dividends received; the allocation and distribution of interest expense, foreign income taxes and certain life insurance company deductions; the definition of a foreign income tax and a tax in lieu of income tax (including the attribution requirement); the definition of foreign branch income; and when foreign taxes accrue and can be claimed as a credit. The final rule also includes clarifying rules relating to intangible income of foreign origin.
The attribution requirement (f/k/a the jurisdictional connection requirement)
As a dollar-for-dollar US income tax credit, the FTC aims to mitigate double taxation of foreign source income. Under the old regulations on when a foreign tax will be chargeable for U.S. purposes, issued in 1983, a foreign levy was chargeable if it was a tax and had the predominant character of a tax on income in the American sense. Until now, FTC regulations have not considered whether there is a sufficient nexus between the income subject to tax and the foreign jurisdiction imposing the tax.
The Treasury Department and the IRS decided it was time to modernize old regulations to meet changing circumstances, especially given the taxation of the digital economy. The preamble to the final rule explains that a nexus requirement is necessary because “many foreign jurisdictions have ignored international tax standards to claim additional tax revenue, resulting in new extraterritorial taxes that deviate from many respects of US tax rules and traditional norms of international tax jurisdiction.
The jurisdictional connection requirement was introduced in the draft regulations published in November 2020. Under the draft regulations, a foreign tax imposed on a non-resident would satisfy the jurisdictional connection requirement in one of three ways (1) whether the tax is reasonably attributable to the activities of the non-resident in the foreign country (the “activity-based requirement”); (2) if the tax is based on income from the taxing country (but only if the sourcing rules in the foreign country are reasonably similar to the sourcing rules in the United States) (the “requirement based on source”); or (3) if the tax is based on income from the sale or disposition of certain immovable or movable property situated in the country imposing the tax (the “Property Based Requirement”).
Despite intense criticism, the final rule adopts the jurisdictional nexus requirement introduced in the draft rule. Although the final rule makes several changes to the requirement, including replacing the phrase “jurisdictional nexus requirement” with “attribution requirement”, the requirement in the final rule is largely the same as that in the proposed settlement. The preamble to the final rule provides an overview of the amended term, noting that the term “attribution requirement” replaces “jurisdictional nexus requirement” to “more clearly indicate that the rule provides limits on the scope of gross revenues and costs. which are attributable to an activity of the taxpayer and therefore duly included in the foreign tax base for the purposes of applying the other components of the net gain requirement. »
The IRS received a number of comments on the proposed regulations and responded to those comments in detail in the preamble to the final regulations. In response to certain comments, the IRS has modified and clarified certain aspects of the attribution requirement.
Changes to the activity-based requirement
The final rule provides further clarification on the activity-based requirement. For example, the final rule clarifies that the activity-based requirement is not satisfied where the non-resident is deemed to have a trade or business in the taxing jurisdiction because of the activities carried on by another person, except in the case of a party acting on behalf of the non-resident. The final rule also clarifies that a foreign tax law that attributes income to a nonresident based on the mere location of persons purchasing from the nonresident does not satisfy the activity-based requirement.
Source Based Requirement Changes
The final rule amends the source-based requirement to provide additional flexibility and clarity to address comments that it would be complex to determine whether foreign sourcing rules are reasonably similar to U.S. sourcing rules, which which would cause significant uncertainty because US procurement rules are not well defined. . Although the foreign sourcing rules must be reasonably similar to the sourcing rules under the Code, the final rule provides that the application of the sourcing rules by foreign tax law need not be consistent with all respects to the interpretation that applies for United States income tax purposes. While many commentators raised concerns about the increased incidence of non-exempt double taxation of cross-border payments for digital services when the source-based requirement is implemented, the IRS declined to exclude digital services.
For greater certainty, the final rule clarifies the source principles that foreign tax law must apply to be considered reasonably similar to US source rules. For example, gross revenue from services must arise from the location where the services are performed, and gross revenue from gross revenue from royalties must arise from the place of use or right to use the intangible. It should be noted that the US source rule for royalties is unusual compared to typical source rules for royalties around the world (which are often residency-based), raising the question of whether many withholdings to the foreign source on the royalties will be creditable in the United States. .
Ownership Requirement Changes
The final settlement specifies when the ownership requirement will be satisfied. A foreign tax may include in its base, under rules reasonably similar to the United States rules under the Foreign Real Estate Investment Tax Act of 1980, gross receipts attributable to (1) the sale or disposal of real estate located in the foreign country; or (2) the disposition of an interest in a corporation or other entity that is a resident of the foreign country that owns real property located in the foreign country. In addition, the final rule clarifies that a foreign tax imposed on the basis of the situs of a property may include in its base, under rules reasonably similar to the U.S. effectively related income rules, gains from (1) the sale or other disposition of property forming part of the business property of a taxable presence in the foreign country; and (2) the disposition of an interest in a partnership or other flow-through entity that has a taxable presence in the foreign country to the extent that the gains are attributable to the business property of the entity in that foreign country. The preamble to the final rule states that a foreign tax on any other gain of a non-resident will not satisfy the property-based requirement.
Changes regarding treaty interaction
The IRS has received a number of comments expressing concern about how the jurisdictional nexus rule (now the attribution requirement) will affect the application of tax treaties between the United States and foreign jurisdictions. In response to these comments, the final rule clarifies that a foreign tax that is treated as an income tax under the Double Taxation Relief Article of the relevant U.S. tax treaty will meet the definition of a foreign income tax for US citizens and residents. elect to claim benefits under this Agreement. As noted in the preamble to the final rule, U.S. multinationals with controlled foreign corporations (CFCs) should be aware that SFCs are not treated as U.S. residents under U.S. tax treaties, so SFCs residing in a third country are not eligible for benefits under US tax treaties. Thus, the final regulations specify that taxes paid to a US treaty partner by a third-country CFC are treated as a separate levy that must independently meet the requirements to be creditable.
Persistent Questions and Problems
While the final rule no doubt provides much-needed clarity on the attribution requirement, taxpayers and practitioners are still unsure about several important issues. Among them, the final rule, surprisingly, does not provide a rule for determining how “reasonably similar” a foreign rule must be for the purposes of the source-based requirement. This leaves a lot of gray area for taxpayers and the IRS when implementing the source-based requirement. Another open question is how the allocation requirement will interact with the first pillar of the OECD, which, when enacted, will impose destination-based sourcing requirements that are inconsistent with the allocation requirement. . Going forward, taxpayers should keep the attribution requirement in mind when determining their FTCs, as certain foreign taxes that were previously creditable in the United States may now be treated differently.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.