Treasury and IRS release corrections to 2021 foreign tax credit regulations

In brief

Treasury on July 26, 2022 released corrections (2022-15867 and 2022-15868) to the final foreign tax credit (FTC) regulations that were published on January 4, 2022 in the Federal Register (2021 regulations). The 2022-15867 corrections address ‘substantive issues’ under Sections 245A, 338, 367, 861, 901, 904, 905, 951A, and 960 including clarifying the cost recovery requirement of the definition of a foreign income tax. The 2022-15868 corrections address ‘drafting issues’ in the preambles addressing regulations under Section 861, 901, and 903.

The 2021 regulations address, among other things, the definition of a foreign income tax and a tax in lieu of an income tax; the disallowance of a credit or deduction for foreign income taxes with respect to dividends eligible for a Section 245A dividends-received deduction; the allocation and apportionment of interest expense, foreign income tax expense, and certain deductions of life insurance companies; the definition of foreign branch category income; and the time at which foreign taxes accrue and can be claimed as a credit.

While these corrections are effective on July 27, 2022, the date of publication in the Federal Register, the 2022-15868 corrections are applicable on or after January 4, 2022, and certain provisions of the 2022-15867 corrections are applicable to periods beginning before that date. The various applicability dates are summarized in the table at the end of this document.

The takeaway: While the corrections clarify narrow portions of the 2021 regulations, the corrections do not make sweeping changes to the regulations or their structure. Treasury has indicated additional changes will be forthcoming, including proposed relief from the attribution requirement for certain royalty withholding taxes.

Cost recovery requirement

Under the 2021 regulations, for a foreign tax to satisfy the cost recovery requirement described in Treas. Reg. sec. 1.901-2(b)(4) of the 2021 regulations, the tax base must be computed by reducing gross receipts by significant costs and expenses (including significant capital expenditures) that are attributable under reasonable principles to such gross receipts. A cost or expense is significant if it meets one of two criteria. First, the following expenditures (as characterized under foreign law) are per se significant: capital expenditures, interest, rents, royalties, services, and R&E. Second, any other cost or expense is significant if it constitutes a significant portion of the total costs and expenses of all taxpayers in the aggregate that are subject to the foreign tax. When considering whether the foreign tax law permits the recovery of the significant costs and expenses, the costs and expenses may be recovered at a different time than they would be under the Code, unless the time of recovery is so much later as to effectively constitute a denial of such recovery (e.g., after the property becomes worthless or is disposed of). 

The corrections remove the modifier ‘significant’ from capital expenditures that are included in significant costs and expenses that must be recovered. The corrections also broaden the rules for when expenses must be recovered, by reorienting the specific rules regarding expenses capitalized under foreign law. Rather than prohibiting expenses with respect to property from being recovered after the property becomes worthless or disposed of, the regulations explicitly permit the recovery of expenses upon the occurrence of future events, including upon the property becoming worthless or being disposed of. 

Under the 2021 regulations, a foreign levy would be treated as permitting the recovery of significant costs and expenses even if a portion of such expenses were disallowed, if the principles underlying the disallowances were consistent with the principles disallowing deductions under the Code. The 2021 regulations used the limitations under Sections 163(j), 267A, and 162 as analogies to permissible limitations and/or disallowances under foreign law.

The corrections revise Treas. Reg. sec. 1.901-2(b)(4)(i)(C)(1) to note that foreign tax law is considered to permit recovery of significant costs and expenses even if recovery of all or a portion of certain costs or expenses is disallowed, if such disallowance is consistent with any principle underlying disallowances required under the Code, including public policy concerns. The corrections remove references to the principles similar to Section 163(j) and Section 267A; however, they continue to reference the principles underlying those disallowances (i.e., the principles underlying interest deduction limitations, disallowances in connection with hybrid transactions, and disallowances under Section 162).

Observation: Overall, the corrections to the cost recovery requirement are not as extensive as most in the tax community believe are needed, and fail to adequately address the significant administrative burdens the revised requirement has placed on taxpayers. However, the corrections do appear to begin the process of adapting the strict standard of the 2021 regulations so that it is more flexible and takes into account the wide variety of foreign income tax regimes around the world. The corrections reflect both a tightening and a loosening of the existing rules. For example, the removal of the word “significant” appears intended to tighten the cost recovery requirement by requiring the foreign tax law to allow recovery of all capital expenditures, unless the failure to allow recovery of such expenditures can be explained. In contrast, the relaxed standard for the timing of recovery provides certainty for foreign tax regimes that do not permit the amortization of certain capitalized costs that may be amortized for U.S. federal income tax purposes (e.g., acquired goodwill), so long as the capitalized costs may be recovered upon the actual or deemed disposition of the property. Further, the revisions are helpful in that they also re-emphasize that foreign law disallowances must be consistent with any principle underlying disallowances under the Code, rather than matching specific U.S. disallowance rules. Taxpayers await future revisions and/or examples explaining the permissible principles, which taxpayers never had to identify until the 2021 regulations.

Allocation and apportionment of foreign income taxes

The 2021 regulations provided additional detail governing the allocation and apportionment of foreign income taxes with respect to disregarded payments. 

Disregarded payments in connection with disregarded sales or exchanges of property

The corrections narrow the application of the special rule in Treas. Reg. sec. 1.861-20(d)(3)(v)(D) for disregarded payments made in exchange for property, to exclude the portions of disregarded payments made in connection with disregarded sales or exchanges of property that are reattribution payments. The definitions of a contribution and a remittance were also updated to clarify that they do not include any disregarded payment made in connection with disregarded sales or exchanges of property. 

Observation: Under the 2021 regulations, there was uncertainty regarding how two existing rules apply to allocate and apportion foreign income tax arising from disregarded dispositions of property: the reattribution payment rule of Treas. Reg. sec. 1.861-20(d)(3)(v)(B), which characterizes foreign tax by reference to actual regarded income of the payor taxable unit to which a disregarded payment is allocable, to the extent of that regarded income, and the special rule under Treas. Reg. sec. 1.861-20(d)(3)(v)(D), which characterizes the foreign tax by reference to the income that would be recognized for U.S. tax purposes if the disposition had been regarded. For example, if one disregarded entity of a CFC sells inventory to another disregarded entity of the same CFC, the resulting foreign tax could have been characterized either based on any regarded income that the purchasing disregarded entity recognizes with respect to the inventory, or based on a hypothetical regarded sale between the disregarded entities. 

The corrections clarify how these rules work together. The reattribution rule applies first, so, to the extent of the purchasing disregarded entity’s regarded income, the foreign tax is characterized by reference to that income. The special rule under Treas. Reg. sec. 1.861-20(d)(3)(v)(D) for disregarded property transactions only applies if the amount of the disregarded payment exceeds the purchasing disregarded entity’s regarded income. In that case, the excess is characterized by reference to a hypothetical sale of the property, rather than under the remittance or contribution rule. This clarification also affects the operation of other portions of the disregarded payment rules. First, it ensures that disregarded property transactions are not treated as remittances or contributions, which tend to assign tax to the residual category, after which it cannot be deemed paid by a US shareholder. Second, it also is relevant to the determination of a taxable unit’s assets for purposes of applying the remittance rules to disregarded distributions of property by a taxable unit.

Key applicability dates of corrections