Regulations create a new approach to the creditability of foreign taxes

Editor: Rochelle Hodes, J.D., LL.M.

For taxpayers who derive income from multiple countries, double taxation is among the chief concerns. U.S. federal income tax law addresses that concern primarily by offering a foreign tax credit (FTC). The FTC allows a taxpayer that has paid taxes in another country to take a credit for those taxes against the taxpayer’s U.S. federal income tax obligations.

FTC rules before 2022

Former Regs. Sec. 1.901-2, issued in 1983 (T.D. 7918, 48 Fed. Reg. 46276), defined a creditable foreign tax as a foreign tax that has a “predominant character of an income tax in the U.S. sense” (former Regs. Sec. 1.901-2(a)(1)(iii)). Under the regulation, the predominantcharacter standard was met if the foreign tax was likely to reach net gain in normal circumstances (net gain requirement) and was not a soak-up tax, the liability for which depends on the availability of an FTC in another country. The regulation further provided that the net gain requirement was established if three criteria were satisfied: (1) a foreign tax was triggered based on the occurrence of an income realization event (the realization requirement); (2) the tax was imposed on the basis of gross receipts (the gross receipts requirement); and (3) the tax base was computed by reducing the gross receipts by attributable significant costs and expenses (the net income requirement). For nearly four decades, this version of Regs. Sec. 1.901-2 established the baseline for creditability of foreign taxes against U.S. tax based on the predominant-character standard.

Regulatory changes

In November 2020, the IRS issued proposed regulations (REG-101657-20, 85 Fed. Reg. 72078 (Nov. 22, 2020)) that made dramatic changes to the definition of a creditable tax, designed to ensure that new digital services taxes enacted by several foreign jurisdictions would not qualify as a creditable tax. The proposed regulations removed the predominantcharacter standard and replaced it with an absolute test based on meeting the net gain requirement and an added jurisdictional nexus requirement (see Prop. Regs. Sec. 1.901-2(c)). The preamble provided very little discussion of the rationale behind the abandonment of the predominant-character standard despite its long-standing significance as the linchpin of creditability within the FTC regime.

The added jurisdictional nexus requirement provided that a creditable tax must be based on arm’s-length transfer pricing principles (Prop. Regs. Sec. 1.901-2(c)(2)). Additionally, if the foreign jurisdiction assesses tax against a nonresident taxpayer, taxing nexus must be based on one of the following tests, depending on the type of income that is being taxed (Prop. Regs. Sec. 1. 901-2(c)(1)):

• Activity within the taxing jurisdiction;
• Source of income within the jurisdiction (based on U.S.-style sourcing principles); or
• Assets located in a taxing jurisdiction (this test has very limited applicability).

The material changes that the proposed regulations made to the net gain requirement fell within the secondary net income requirement. The substance of these changes was to require that, to be creditable, a foreign tax must allow deductions that closely mirror the rules and rationale for deductibility under U. S. law.

The proposed regulations were finalized in January 2022 (T.D. 9959, 87 Fed. Reg. 276 (Jan. 4, 2022)). The final regulations closely followed the proposed regulations, adopting the proposed regulations’ change of the name of the “net income requirement” to the “cost recovery requirement,” although they changed the name of the “jurisdictional nexus requirement” to the “attribution requirement.” The final regulations also refined operating rules for the attribution requirement and folded it into the net gain requirement rather than making it an independent requirement (Regs. Sec. 1.901-2(b)(5)).

The overarching theme of the final regulations is that creditability is based on the design of the relevant foreign tax system regardless of the application of the foreign tax to a single, or even the majority of, taxpayers subject to the foreign tax. The final regulations apply to tax years beginning on or after Dec. 28, 2021.

Significant concerns were raised about the new regulations. Some of these concerns were addressed in technical corrections issued in July 2022 (87 Fed. Reg. 45018 (July 27, 2022)), clarifying the new cost recovery requirement. The technical corrections also clarified the interaction between creditability and the effective tax rate as applied to the computation of the global intangible low-taxed income (GILTI) high-tax exclusion. As clarified, only creditable taxes, as determined at the entity level, are taken into account in determining the effective tax rate.

In November 2022, new FTC proposed regulations (REG-112096-22, 87 Fed. Reg. 71271 (Nov. 22, 2022)) were issued that provided limited but meaningful relief for U.S. taxpayers. On the cost recovery front, the 2022 proposed regulations clarified that disallowances under a foreign tax system will not interfere with creditability of the foreign tax if the disallowances are “consistent with any principle underlying the disallowances required under the income tax provisions of the Internal Revenue Code” and that public policy concerns (similar to those under U. S. law) are a basis for the disallowance of the foreign tax (Prop. Regs. Sec. 1. 901-2(b)(4)(i)(F)(1)).

The 2022 proposed regulations also added two safe harbors to the cost recovery requirement: one for disallowances of up to 25% of an expense item and another for disallowances that are no more than either 15% of gross receipts or 30% of taxable income (Prop. Regs. Sec. 1.901-2(b)(4)(i)(C)(2)). The 2022 proposed regulations also created a safe harbor to meet the attribution requirement for royalties that are limited to a single country of use by contract (Prop. Regs. Sec. 1.903-1(c)(2)(iii)(B)). The November 2022 proposed regulations generally apply to tax years beginning on or after Nov. 18, 2022, but taxpayers can elect to apply them immediately.

The regulatory activity of 2022 continues to be the subject of much criticism from the tax community. The changes to the cost recovery requirement and the addition of the attribution requirement require U. S. taxpayers to become experts in the specifics of foreign tax law. The level of analysis required to determine eligibility for the FTC extends far beyond the application of foreign tax law to a given taxpayer. Under the new regulations, U.S. taxpayers must understand if there is any hypothetical application of the foreign tax regime that could cause it to run afoul of the expanded FTC requirements.

Furthermore, questions regarding application of these rules in combination with strict standards set forth in the regulations create considerable uncertainty. For example, prior to the recent change to Brazil’s transfer pricing rules, the conventional wisdom was that Brazilian income tax generally would not be creditable because Brazil’s transfer pricing rules failed to meet the attribution requirement of the 2022 final regulations. However, Brazil’s new transfer pricing regime, effective from Jan. 1, 2024, is presumptively compliant with the U.S. FTC rules because it complies with the Organisation for Economic Co-operation and Development’s (OECD’s) transfer pricing guidelines (see Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD (Jan. 20, 2022)). Brazil permits taxpayers to apply the new transfer pricing regime for the 2023 tax year. However, it is unclear whether opting into Brazil’s new transfer pricing regime for 2023 allows creditability of Brazil’s taxes for 2023 because it is unclear whether the ability to defer the tax until 2024 violates the universality standard and because opting into the regime early could be seen as payment of a noncompulsory tax.

Although the revised FTC regulations were originally intended to address digital services taxes and the harsh and frequently unintended consequences of the pre-2022 FTC rules, there were issues under the 2022 regulations. To provide relief, the IRS issued Notices 2023-55 and 2023-80.

Notice 2023-55

Notice 2023-55, issued on July 21, 2023, permits taxpayers to apply substantial portions of the pre-2022 FTC regulations, including the criteria for meeting a U.S.-style income tax based on the predominant-character standard, for tax years beginning on or after the Dec. 28, 2021, effective date of the January 2022 final regulations and ending on or before Dec. 31, 2023. A taxpayer electing relief is required to apply the pre-2022 FTC regulations for all foreign taxes paid or deemed paid during the relief period.

Under the notice, the concerns regarding whether the payment of Brazil income taxes is creditable virtually disappear for taxpayers electing to apply the relief.

Notice 2023-80

As the Pillar Two initiative has gathered steam and subscribing countries have started adopting enabling legislation, U.S. taxpayers have begun wrestling with the application of the 2022 FTC regulations and facets of Pillar Two. These challenges, along with the growing list of unresolved issues related to how Pillar Two interacts with other anti-abuse measures in U.S. tax law, such as the rules regarding the use of dual consolidated losses under Sec. 1503(d), prompted the IRS to issue Notice 2023-80 on Dec. 11, 2023.

Notice 2023-80 announced the IRS’s intent to issue proposed regulations that, among other things, would not allow the creditability of any Pillar Two final top-up tax that takes into account the U.S. taxpayer’s U.S. federal income tax liability when computing the final top-up tax. Without diving into the intricacies of Pillar Two tax mechanisms, the forthcoming proposed regulations are expected to allow a credit for a qualified domestic minimum top-up tax (QDMTT) (generally, a top-up tax assessed by a local country solely with respect to its own tax base) but not for a tax allocated to a given jurisdiction under an income inclusion rule (IIR) (generally, a top-up tax applied to a parent company with respect to its subsidiaries). The notice does not address the interaction between the FTC rules and the third type of top-up tax under the undertaxed payments rule.

Notice 2023-80 clarifies that each top-up tax is considered a separate levy, which preserves the creditability of the base income tax of countries that adopt a disallowed Pillar Two tax. The notice also provides helpful guidance for partnerships.

Although the notice indicates that the proposed regulations will be effective for tax years ending after Dec. 11, 2023, it extends the relief contained in Notice 2023-55 until guidance withdrawing or modifying the temporary relief is issued (or a later date specified in other guidance). If final regulations are consistent with the guidance on the foreign tax credit provided in the notice, the final regulations will apply regardless of whether the taxpayer applies the temporary relief described in Notice 2023-55.

Some commentators have expressed concern about certain aspects of Notice 2023-80. First, parts of the notice appear to be inconsistent with U.S. support for Pillar Two. Second, the notice excludes final top-up taxes from the computation of the high-tax exception for Subpart F purposes and the high-tax exclusion for GILTI purposes under the Sec. 954 and Sec. 951A regulations. Third, topup taxes that are not creditable under FTC rules also are not deductible by a U. S. taxpayer claiming FTCs for the tax year. Fourth, disallowed top-up taxes are included in the gross-up under Sec. 78 if paid by a controlled foreign corporation. By not only denying the credit but also denying a deduction afforded for other non-income taxes when multinationals operate in jurisdictions that implement Pillar Two, the net effect is that these rules frustrate the U.S. tax policy reason for denying an FTC — allowing double taxation of earnings subject to non-U.S.- style income taxes.

What taxpayers can do now

The continuing updates to the FTC regulations demonstrate a willingness by the IRS to address taxpayer concerns. Taxpayers should consider offering comments or working through a consortium or trade organizations to provide comments on these rules for consideration in future guidance projects. U.S. taxpayers also should consider engaging a qualified tax adviser to perform a thorough analysis of their global tax footprint to evaluate whether each relevant component of regular income tax, IIR tax, and QDMTT in a foreign country is a creditable foreign tax for U.S. tax purposes and whether to elect relief under Notice 2023-55.

Editor notes

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, D.C.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Contributors are members of or associated with Crowe LLP.