Treasury Department Issues Proposed Regulations on Foreign Tax Credit Rules
The U.S. Treasury Department recently issued proposed regulations REG-112096-22 concerning the foreign tax credit (FTC). The proposed regulations include guidance with respect to the reattribution asset rule for purposes of allocating and apportioning foreign taxes, the cost recovery requirement and the attribution rule for withholding tax on royalty payments.
Reattribution Asset Rule
The 2022 FTC final regulations specify rules for allocating and apportioning foreign income tax arising from a disregarded payment, which is used under federal income tax law in allocating foreign gross income to assorted statutory and residual groupings. These final rules state that a portion of a disregarded payment, if any, that causes U.S. gross income of the payer to be reattributed under Regs. Sec. 1.904-4(f)(2) or Regs. Sec. 1.951A-2(c)(7)(ii)(B) to the recipient is treated as a reattribution payment. The rules also state that when there is reattribution of income from a payer to a recipient, there must additionally be a reattribution of the tax book value of the assets that created the reattributed income.
Because the Treasury and IRS determined the reattribution asset rule is not necessary for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, the proposed regulations maintain the general definition of a reattribution asset but are amended to exclude any part of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable units.
Cost Recovery Rule
A foreign tax generally fulfills the cost recovery requirement of Regs. Sec. 1.901-2(b)(4)(i)(A) if the base of the tax is calculated by reducing gross receipts to allow for the recovery of significant costs and expenses attributable to those gross receipts. In response to requests made to the Treasury and IRS after the 2022 final regulations were published, the proposed regulations modify this requirement.
Prop. Regs. Sec. 1.901-2(b)(4)(i) maintains the general cost recovery requirement under the 2022 final regulations but states that the pertinent foreign tax law need only allow for the recovery of substantially all of each item of significant cost or expense. The foreign tax law solely determines whether the recovery of substantially all of each item of significant cost or expense is permitted.
Prop. Regs. Sec. 1.901-2(b)(4)(i)(C)(2) offers a cost recovery requirement safe harbor, where a disallowance of a stated part of one or multiple items of significant cost or expense does not prevent a foreign tax from fulfilling the cost recovery requirement if the part of the item (or items) that is disallowed does not exceed 25%, along with further limits.
Attribution Requirement for Royalty Payments
The 2022 FTC final regulations' source-based attribution requirement states a foreign tax levied on a nonresident's income on the basis of source satisfies the attribution requirement only if the foreign tax law's sourcing rules are reasonably similar to the sourcing rules used for federal income tax purposes. After publication of the final 2022 rules, the Treasury and IRS received requests to modify this requirement for certain royalty withholding taxes by permitting a credit even if a foreign country sources royalties based on the residence of the payer or by employing an alternate standard.
The Treasury and IRS agreed it made sense to afford a limited exception to the requirement when a taxpayer can show that a withholding tax is levied on royalties received in exchange for the right to use intangible property solely within the territory of the taxing jurisdiction. Prop. Regs. Sec. 1.903-1(c)(2)(iii) states a tested foreign tax will meet the requirement if it meets the "single country exception" in Prop. Regs. Sec. 1.903-1(c)(2)(iii)(B). This exception pertains where (1) the income subject to the tested foreign tax is characterized as gross royalty income, and (2) the payment generating such income is made pursuant to a single-country license.
The proposed regulations also state foreign tax law generally applies in determining whether the gross income or receipts from a transaction are characterized as a royalty, except in a transaction regarded as the sale of a copyrighted article under Regs. Sec. 1.861-18, which is treated as a sale of tangible property.
Additionally, a payment is made pursuant to a single-country license if the license agreement under which the payment is made characterizes the payment as a royalty and restricts the territory of the license to the foreign country enacting the tested foreign tax under Proposed Reg. Sec. 1.903-1(c)(2)(iv)(A).
If finalized, the regulations would generally apply to tax years ending on or after the date of publication in the Federal Register. Subject to conditions, taxpayers would also be able to apply the final regulations to previous tax years. Prop. Regs. Sec. 1.861-20(d)(3)(v)(E)(6) would apply to tax years ending on or after the date the regulations are finalized.