Treasury and the IRS release proposed foreign tax credit regulations

In detail

The 2022 FTC proposed regulations are the latest in a series of guidance addressing changes made by the 2017 Tax Cuts and Jobs Act (TCJA). Previously, Treasury and the IRS published proposed FTC regulations on December 17, 2019 (the 2019 FTC proposed regulations), which were finalized on November 12, 2020 (the 2020 FTC final regulations). On the same date, Treasury and the IRS published proposed regulations (the 2020 FTC proposed regulations), which were finalized on January 4, 2022 (the 2021 FTC final regulations). Correcting amendments to the 2021 FTC final regulations were published on July 27, 2022.

The current cost recovery requirement requires the recovery of significant costs and expenses attributable, under reasonable principles, to the gross receipts included in the tax base, and generally requires taxpayers to determine that the reason for a foreign tax law disallowance of a deduction is consistent with the principles underlying disallowances in the Code. The 2022 FTC proposed regulations would retain the 2021 FTC final regulations’ principles-based exception but would make two changes. 

First, the 2022 FTC proposed regulations would relax the cost recovery standard to only require recovery of substantially all of each item of significant cost or expense. 

Second, the 2022 FTC proposed regulations would provide a safe harbor for broadly applicable deduction limitations or add-backs under foreign law. Under the safe harbor, the disallowance of a stated portion of an item of significant cost or expense would not prevent a foreign tax from satisfying the cost recovery requirement if the disallowance/add-back does not exceed 25%. The safe harbor also would permit deduction limitations based on a percentage of revenues or gross income (no more than 15%) or an amount similar to taxable income (no more than 30%). If a taxpayer is within the safe harbor, there is no need to determine the reason for the foreign tax law deduction disallowance. However, if the foreign law disallowance does not meet the safe harbor, or otherwise permit recovery of substantially all of each item of significant cost or expense, the taxpayer must apply principles-based exception to determine whether the foreign tax satisfies the cost recovery requirement.

The 2021 FTC final regulations added an attribution requirement as an element of the net gain requirement to allow a credit for a foreign tax only if the country imposing the tax has sufficient nexus to the taxpayer’s activities or investment of capital that generates the income included in the tax base. The 2022 FTC proposed regulations would provide a limited exception to the source-based attribution requirement of the 2021 FTC final regulations when qualifying a foreign tax as a covered withholding tax under section 903 where the taxpayer can substantiate that a withholding tax is imposed on royalties received in exchange for the right to use intangible property solely within the territory of the taxing jurisdiction. This limited exception generally would apply only if the taxpayer has a written license agreement that provides for the payment of the royalty, and that limits the use of the intangible property giving rise to the royalty payment to the territory of the foreign country imposing the tax, or otherwise specifies the portion of the payment related attributable to such foreign country (“single-country license”).

The 2022 FTC proposed regulations also modify the separate levy rule for withholding taxes imposed on nonresidents to provide that a withholding tax that is imposed on a royalty payment made to a nonresident pursuant to a single-country license is treated as a separate levy from a withholding tax that is imposed on other royalty payments made to such nonresident and from any other withholding taxes imposed on other nonresidents.

Observation: To come within the new single-country license rule and meet the attribution requirement, taxpayers generally must have a license agreement in place that meets the requirements of the regulations at the time a royalty is paid. However, the 2022 FTC proposed regulations provide that taxpayers can execute a license agreement by May 17, 2023 and come within the single-country rule, provided certain requirements are met.

Prior regulatory guidance provides rules for allocating and apportioning foreign income tax arising from a disregarded payment. The 2022 FTC proposed regulations remove the reattribution asset rule for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, and with respect to disregarded sales of inventory property. The 2022 FTC proposed regulations would retain the general definition of reattribution asset but would exclude any portion of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable unit.