Reattribution asset rule
The final regulations require the reattribution of income for purposes of calculating a taxpayer’s foreign tax credit limitation in the case of certain disregarded payments. In those instances, the final regulations also require the reattribution of affected assets, which has a secondary effect on the foreign tax credit limitation because of how it affects expense apportionment. The proposed regulations tweak the rule to eliminate the need to reattribute assets in many cases.
Cost recovery requirement
The final regulations established or modified several requirements for a foreign tax to be creditable against U.S. income tax.
One of the requirements modified by the final regulations, the cost recovery requirement (formerly the net income requirement), is met only if the foreign tax allows for the recovery of significant costs and expenses attributable to gross receipts under reasonable principles to determine the foreign tax base. Costs and expenses related to capital expenditures, interest, rents, royalties, wages, or other payments for services and research and experimentation are identified expressly as significant costs and expenses for purposes of this rule. The foreign law is treated as permitting a recovery of costs and expenses even if the costs and expenses are recovered at a different time than they would be under U.S. tax principles.
Under the final regulations, the cost recovery requirement could be met even if foreign tax law disallows all or a portion of an item treated as significant costs or expenses provided that the rule under which the foreign jurisdiction disallows the costs or expenses is consistent with principles underlying how the costs or expenses are disallowed under U.S. tax law.
The proposed regulations, which generally retain the cost recovery requirement under the final regulations, provide helpful clarifications. For instance, under the proposed regulations, the cost recovery requirement can be satisfied if foreign law allows recovery of substantially all of each item of significant cost or expense based solely on the terms of the foreign law without regard to whether the treatment of the item under foreign law conforms with the treatment under U.S. tax principles. The proposed regulations also add a safe harbor if foreign tax law uses either a stated percentage or a cap to disallow all or a portion of any significant cost or expense item. Under the safe harbor, the cost recovery requirement will be met if either:
- The stated percentage for disallowance does not exceed 25%
- The cap is not less than 15% of gross receipts, gross income, or a similar measure, or if the cap is not less than 30% of taxable income
Attribution requirement for royalties
The final regulations added an attribution requirement specifying that the sourcing rules employed by the foreign tax authority must align with the sourcing rules under U.S. tax law. Consequently, a foreign withholding tax on royalties is creditable only if the foreign tax law sources royalties based on the place of use of, or the right to use, the intangible property as required under U.S. tax law. The attribution requirement does not, however, override taxes expressly covered in U.S. tax treaties.
Many countries impose withholding taxes on royalties based on the residence of the payer. Such withholding taxes on royalties is not aligned with the royalty sourcing rule under U.S. tax law and, therefore, no longer is creditable under the attribution requirement in the final regulations.
The proposed regulations provide a narrow but important exception to the attribution requirement referred to as the “single-country exception.” Under this exception, the source-based attribution requirement will be deemed to be met if the taxpayer has a written license agreement that both:
- Specifies the payment as a royalty
- Limits the territory of the license to the country imposing the relevant foreign tax
The single-country exception can apply to royalties attributable to a single-country portion of a broader license agreement if the agreement carves out the single-country elements. For the single-country exception to apply, the required agreement pursuant to which the qualifying royalty is paid must be executed no later than the date of the royalty payment.
Crowe observation
Taxpayers with use licenses for the use of intellectual property in multiple countries should consider revising existing agreements to carve out the rights of the use license in each country to meet the single-country exception.
Applicability dates
The general effective date of the proposed regulations is for taxable years ending on or after Nov. 22, 2022. However, once the proposed regulations are finalized, taxpayers may choose to apply some or all of the final regulations to earlier taxable years, subject to certain conditions.
In addition, taxpayers may rely on all or part of the proposed regulations until the effective date of final regulations, subject to certain conditions. For instance:
- The reattribution asset rule in the proposed regulations may be used for tax years ending on or after Dec. 31, 2019, and before the proposed regulations are finalized.
- The proposed rules for the cost recovery requirement and the attribution requirement for royalties can be used for tax years ending on or after Dec. 28, 2021. However, in the case of the attribution requirement for royalties paid on or before May 17, 2023, the required agreement must be executed on or before May 17, 2023, and it must state that any previously paid royalties are considered paid pursuant to the agreement’s terms.
Crowe observation
The proposed regulations contain several helpful clarifications that taxpayers might be able to apply to years prior to the effective date of any final rules. Taxpayers should work closely with their tax advisers to determine how to approach the proposed regulations.
Looking ahead
In some ways, the proposed regulations provide relief from the requirements for claiming the foreign tax credit under the final regulations. The safe harbor for the cost recovery requirement and the revised reattribution asset rule would significantly reduce the burden for taxpayers when determining which foreign taxes are creditable, and the single-country exception provides both certainty and limited relief on the creditability of withholding taxes under the attribution requirement.
Even after publication of these proposed regulations, concerns remain with respect to the final regulations, including, for example, how the arm’s-length principle for transfer pricing applies under the attribution requirement. Comments on the proposed regulations are due by Jan. 23, 2023. Government officials have indicated that in addition to comments on the proposed regulations, they are open to comments on issues that were not addressed by the proposed regulations.
