Final foreign tax credit regs and the new attribution requirement

Following are some of the key takeaways from the final regulations:

Creditable foreign income tax

To be creditable, a foreign income tax must satisfy the net gain requirement, which includes tests to establish realization, gross receipts, and cost recovery. The final regulations add more flexibility and provide additional examples to clarify the net gain requirement. The net gain requirement does not require strict conformity between foreign and U.S. tax law. However, the final regulations do require that the foreign tax be consistent with the principles reflected in the IRC for it to be considered an income tax under U.S. law. The final regulations also remove the predominant character standard that prevented isolated exceptions from disqualifying the creditability of a foreign tax.

Attribution requirement

The controversial jurisdictional nexus requirement in the proposed regulations was renamed the attribution requirement and incorporated into the net gain requirement in the final regulations.

Under the final regulations, attribution depends on whether a taxpayer is a resident or nonresident of the jurisdiction imposing the tax. If the taxpayer is a nonresident of the taxing country, the foreign tax satisfies the attribution requirement if one of the following three nexus tests is met:

• Activities-based nexus. This type of nexus refers to the conduct of activities within the foreign country, including assets, risks, and functions, and generally can be met under similar rules for determining effectively connected income under Section 864(c). However, the mere location of customers, users, or other similar destination-based criteria will not satisfy the test.
• Property-based nexus. This test is met if real property is located in the foreign country and gross receipts attributable to the sale of real property – as well as the disposition of an interest in a corporation or other entity that owns the real property located in that country – drive the foreign taxation. The final regulations clarify that gains derived from the disposition of an interest in a flow-through entity that has a taxable presence and business property in the foreign country also meet the property-based nexus criterion.
• Source-based nexus. This test is met if the foreign sourcing rules for the jurisdiction are reasonably similar to the U.S. sourcing rules, although the foreign rules do not need to conform in all respects. The final regulations provide rules for determining what “reasonably similar” means. When foreign law and U.S. law characterize gross income or gross receipts differently, the final regulations provide that the foreign law characterization governs, except in a few cases where an additional set of requirements exists. The final regulations also provide the following guidance with respect to source-based nexus in the case of services, royalties, and copyrights:
  • Services. Sourcing of service income is based on where the services are performed and not the location of the service recipient. Thus, a foreign jurisdiction’s withholding tax imposed on payments for services performed in the country imposing the tax would meet the source-based nexus test, but a withholding tax on fees for technical services performed outside of that country would not, regardless of the location of the recipient.
  • Royalties. Gross income from royalties must be sourced by the foreign jurisdiction based on the place of use or the right to use the underlying intangible property. Unfortunately, meeting source-based nexus for royalties could mean forgoing withholding tax credits that traditionally have been allowed because many foreign countries either do not have rules for sourcing royalty income or source it based on the residence of the payer.
  • Sale of copyrighted articles. Only transactions treated as a sale of tangible property meet the source-based nexus test under the attribution requirement. If the sale of a copyrighted article is treated as a license under foreign law and the foreign jurisdiction imposes a withholding tax, for example in cloud-computing and technology-enabled and digital transactions, the transaction might not qualify as source-based nexus for copyrighted articles under the attribution requirement.

Taxpayers meeting one of these nexus tests should carefully consider the impact on other requirements for claiming the foreign tax credit. For instance, the changes within the source-based nexus rules shift the focus of what is a creditable foreign tax, which makes the determination more rigid in many cases. In addition, foreign tax credits for foreign withholding taxes on traditionally creditable taxes may be denied, except in some cases where the U.S. taxpayer claims benefits under a U.S. tax treaty, which are not affected by these rules.

Even when the taxpayer is a resident of the foreign country, transactions must be based on arm’s-length pricing, and foreign tax law cannot use a destination-based criterion as a significant factor. These attribution requirements apply to the foreign tax system as a whole and cannot be merely coincidental based on a given taxpayer’s facts.

Looking ahead

The effective dates in the final regulations are a bit complex and vary by provision. While many provisions are effective for tax years beginning on or after Dec. 28, 2021, some provisions use the effective dates from the proposed regulations, which could mean a provision applies to earlier dates or even prior tax years. Taxpayers should carefully review the final regulations and consult their tax advisers for assistance.