Back on December 28, 2021, the IRS issued final regulations that significantly change long-standing principles for determining eligibility of a foreign tax for the foreign tax credit. Technical corrections were then published on July 27, 2022.
The final regs apply to foreign taxes paid or accrued in tax years beginning on or after December 28, 2021. They mark a departure from long-standing practice by imposing a new attribution requirement in addition to the existing realization, gross receipts and cost recovery requirements. The regs also tighten the existing rules governing the creditability of foreign taxes.
Net Income Tax
The basic requirements for creditability of a foreign levy remain the same. First, the foreign levy must be a tax; that is, a compulsory payment to a foreign government that’s for revenue raising and not for punishment or other purposes. Second, the foreign levy must be either a net income tax or a tax “in lieu of” an income tax.
To qualify as a net income tax, the foreign tax must satisfy the four prongs of the net gain test:
- The realization requirement,
- The gross receipts requirement,
- The cost recovery requirement, and
- The attribution requirement.
Previous regs contained only the first three requirements, with the cost recovery requirement formerly being called the “net income requirement.” Also, previous regulations mandated that only the “predominant character” of the foreign income tax must satisfy each of the three requirements. The current final regs eliminate this focus on the operation of foreign tax. Instead, they hone in on the terms of foreign tax law.
As mentioned, the most significant change made by the final regs is the addition of the attribution requirement. It governs the inclusion of gross receipts and costs in the base of the foreign tax. Separate attribution requirements apply for taxes on residents and taxes on nonresidents. Other requirements and technical details apply as well.
The new attribution requirement harbors significant potential for denial of creditability if a foreign tax system doesn’t, under its terms (regardless of its substance or implementation), follow U.S. income tax treatment of transactions. This includes (with respect to the sourcing of income) allowable deductions and the application of the arm’s-length principle. Tax treaties might preserve creditability in limited circumstances.
Taxes “In Lieu Of” an Income Tax
To qualify as a tax “in lieu of” an income tax, a tax must be foreign and satisfy the substitution requirement. A “tested foreign tax” — that is, a foreign tax being examined under these criteria — satisfies the substitution requirement by meeting four conditions:
- The foreign country imposes a separate generally applicable income tax,
- No other net income tax, including the generally applicable income tax, is imposed in addition to the tested foreign tax on the amounts that form the base of the tested foreign tax,
- But for the tested foreign tax, the generally applicable income tax would be imposed on the income otherwise taxed under the tested foreign tax, and
- If the generally applicable income tax were applied to the income taxed under the tested foreign tax, such a generally applicable income tax or separate levy would meet the attribution requirement. (This condition could also involve a hypothetical new tax that’s a separate levy with respect to the generally applicable income tax.)
The “but for” requirement is a narrowing condition requiring proof that the imposition of the tested foreign tax bears a close connection to the failure to impose the generally applicable foreign tax.
Alternatively, a tax may qualify as “in lieu of” an income tax by meeting the definition of a “covered withholding tax.” This is a withholding tax imposed on the gross income of nonresidents that’s not in addition to any net income tax imposed by the foreign country on any portion of the net income attributable to the gross income subject to the tested foreign tax.
Stated differently, the foreign country may not impose — on the same gross income — both a covered withholding tax and a net income tax. In addition, the income subject to the covered withholding tax must satisfy the attribution requirement.
A Question of Creditability
The final regs significantly modify the requirements that a foreign tax must satisfy to be creditable, marking a departure from long-standing U.S. government policy on the foreign tax credit. For this reason, they’ve generated great concern among business leaders and sparked debate among politicians.
Multinational companies could face increased compliance challenges and costs from having to conduct detailed analyses of foreign tax systems. Additional compliance challenges and costs may arise from the complex new attribution requirement alone.
If yours is a multinational business, consult your CPA to assess the impact of the final regs. You may also want to call upon your tax advisor for assistance submitting comments on future regulatory developments that might shift the direction of tax policy in this area.
We Can Help
If you would like to discuss anything contained in this alert or have questions, please contact us.
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.