On January 4, 2022, the Treasury and the IRS issued final regulations (“Final Regulations”) that deny a foreign tax credit (“FTC”) for certain foreign withholding taxes. The previously issued proposed regulations were intended to limit the credibility of recently imposed foreign taxes that had disregarded international taxing norms, most of which had targeted digital services. The Treasury and IRS reasoned that because the digital economy did not exist at the time the FTC provisions were originally written, it was necessary to “more clearly delineate the circumstances in which a tax does not qualify as an income tax in the U.S. due to the foreign jurisdiction’s unreasonable assertion of jurisdictional taxing authority.”
As a result of the overhaul, whether as collateral damage or by intentional design, many foreign withholding taxes—specifically those applied to services and royalties income—may no longer be creditable. The Final Regulations introduce an “Attribution Requirement” that applies more generally to the credibility of foreign income taxes and is far more restrictive than the previous FTC rules. Furthermore, one subset of this Attribution Requirement—the Source-Based Attribution Requirement—specifically applies in determining the credibility of foreign withholding taxes.
The Source-Based Attribution Requirement
The Final Regulations provide that for a foreign withholding tax to be creditable the foreign withholding tax must, among other requirements, be (i) limited to gross income arising from sources within the foreign country and (ii) determined by sourcing rules that are “reasonably similar” to the U.S. sourcing rules (the Source-Based Attribution Requirement). This Source-Based Attribution Requirement is the primary reason why certain foreign withholding taxes on royalties and services may no longer be creditable.
The U.S. sources income from services and royalties to the place of performance and place of use, respectively. However, many Latin American and Asian countries source the income to the residence of payor. While this difference may be subtle, it can be very troubling for U.S. entities operating in those countries because of the “reasonably similar” rule under the Source-Based Attribution Requirement.
For example, in Peru, services income paid to a non-resident is subject to withholding tax regardless of where the services are performed. As such, any Peruvian withholding taxes on services may not be creditable under the FTC rules. This is true even when a U.S. corporation performs services in Peru for a Peruvian entity. In such a case, the U.S. and Peruvian sourcing rules would have the same effect, but the rules themselves are not reasonably similar.
The same is true with respect to certain royalty payments from India. India sources such payments to the residence of the payor. Therefore, these withholding taxes may not be creditable because of the Source-Based Attribution Requirement.
Interplay with U.S. Tax Treaties
The Final Regulations clarify that a foreign tax that is treated as an income tax under the “relief from double taxation” article of an income tax treaty is creditable. However, because controlled foreign corporations (CFC) are not treated as U.S. residents under U.S. income tax treaties, they do not qualify for treaty benefits. Therefore, foreign withholding taxes paid by a CFC must qualify under the new Final Regulations to qualify as being creditable.
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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.