Rule2021-27887
Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
January 4, 2022
Effective
March 7, 2022
Issuing agencies
Treasury DepartmentInternal Revenue Service
Abstract
This document contains final regulations relating to the foreign tax credit, including the disallowance of a credit or deduction for foreign income taxes with respect to dividends eligible for a dividends-received deduction; the allocation and apportionment of interest expense, foreign income tax expense, and certain deductions of life insurance companies; the definition of a foreign income tax and a tax in lieu of an income tax; the definition of foreign branch category income; and the time at which foreign taxes accrue and can be claimed as a credit. This document also contains final regulations clarifying rules relating to foreign-derived intangible income (FDII). The final regulations affect taxpayers that claim credits or deductions for foreign income taxes, or that claim a deduction for FDII.
Full Text
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[Federal Register Volume 87, Number 2 (Tuesday, January 4, 2022)]
[Rules and Regulations]
[Pages 276-376]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2021-27887]
[[Page 275]]
Vol. 87
Tuesday,
No. 2
January 4, 2022
Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Guidance Related to the Foreign Tax Credit; Clarification of Foreign-
Derived Intangible Income; Final Rule
Federal Register / Vol. 87 , No. 2 / Tuesday, January 4, 2022 / Rules
and Regulations
[[Page 276]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9959]
RIN 1545-BP70
Guidance Related to the Foreign Tax Credit; Clarification of
Foreign-Derived Intangible Income
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
foreign tax credit, including the disallowance of a credit or deduction
for foreign income taxes with respect to dividends eligible for a
dividends-received deduction; the allocation and apportionment of
interest expense, foreign income tax expense, and certain deductions of
life insurance companies; the definition of a foreign income tax and a
tax in lieu of an income tax; the definition of foreign branch category
income; and the time at which foreign taxes accrue and can be claimed
as a credit. This document also contains final regulations clarifying
rules relating to foreign-derived intangible income (FDII). The final
regulations affect taxpayers that claim credits or deductions for
foreign income taxes, or that claim a deduction for FDII.
DATES:
Effective date: These regulations are effective on March 7, 2022.
Applicability dates: For dates of applicability, see Sec. Sec.
1.164-2(i), 1.245A(d)-1(f), 1.336-5, 1.338-9(d)(4), 1.367(b)-7(h),
1.367(b)-10(e), 1.861-3(e), 1.861-9(k), 1.861-10(h), 1.861-14(k),
1.861-20(i), 1.901-1(j), 1.901-2(h), 1.903-1(e), 1.904-6(g), 1.905-
1(h), 1.905-3(d), 1.951A-7, and 1.960-7.
FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec. 1.245A(d)-1,
1.336-2, 1.338-9, 1.861-3, 1.861-20, 1.904-6, 1.960-1, and 1.960-2,
Suzanne M. Walsh, (202) 317-4908; concerning Sec. Sec. 1.250(b)-1,
1.861-8, 1.861-9, and 1.861-14, Jeffrey P. Cowan, (202) 317-4924;
concerning Sec. 1.250(b)-5, Brad McCormack, (202) 317-6911; concerning
Sec. Sec. 1.164-2, 1.901-1, 1.901-2, 1.903-1, 1.905-1, and 1.905-3,
Tianlin (Laura) Shi, (202) 317-6987; concerning Sec. Sec. 1.367(b)-3,
1.367(b)-4, and 1.367(b)-10, Logan Kincheloe, (202) 317-6075;
concerning Sec. Sec. 1.367(b)-7, 1.861-10, and 1.904-4, Jeffrey L.
Parry, (202) 317-4916; concerning Sec. Sec. 1.951A-2 and 1.951A-7,
Jorge M. Oben and Larry Pounders, (202) 317-6934 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Background
On December 7, 2018, the Treasury Department and the IRS published
proposed regulations (REG-105600-18) relating to foreign tax credits in
the Federal Register (83 FR 63200) (the ``2018 FTC proposed
regulations''). Those regulations addressed several significant changes
that the Tax Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054 (2017))
(the ``TCJA'') made with respect to the foreign tax credit rules and
related rules for allocating and apportioning deductions in determining
the foreign tax credit limitation. Certain portions of the 2018 FTC
proposed regulations were finalized as part of TD 9866, published in
the Federal Register (84 FR 29288) on June 21, 2019. The remaining
portions of the 2018 FTC proposed regulations were finalized in TD
9882, published in the Federal Register on December 17, 2019 (84 FR
69022) (the ``2019 FTC final regulations''). On the same date, new
proposed regulations (REG-105495-19) addressing changes made by the
TCJA as well as other related foreign tax credit rules were published
in the Federal Register (84 FR 69124) (the ``2019 FTC proposed
regulations''). Correcting amendments to the 2019 FTC final regulations
and the 2019 FTC proposed regulations were published in the Federal
Register on May 15, 2020. See 85 FR 29323 (2019 FTC final regulations)
and 85 FR 29368 (2019 FTC proposed regulations). The 2019 FTC proposed
regulations were finalized as part of TD 9922, published in the Federal
Register (85 FR 71998) on November 12, 2020 (the ``2020 FTC final
regulations''). On the same date, the Treasury Department and the IRS
published proposed regulations (REG-101657-20) in the Federal Register
(85 FR 72078) (the ``2020 FTC proposed regulations''). The 2020 FTC
proposed regulations addressed changes made by the TCJA and other
foreign tax credit issues. Correcting amendments to the 2020 FTC final
regulations were published in the Federal Register on October 1, 2021.
See 86 FR 54367. A public hearing on the 2020 FTC proposed regulations
was held on April 7, 2021.
On July 15, 2020, the Treasury Department and the IRS finalized
regulations under section 250 (the ``section 250 regulations'') in TD
9901, published in the Federal Register (85 FR 43042). The 2020 FTC
proposed regulations also included revisions to the section 250
regulations.
This document contains final regulations (the ``final
regulations'') addressing the following: (1) The determination of
foreign income taxes subject to the credit and deduction disallowance
provisions of section 245A(d); (2) the determination of oil and gas
extraction income from domestic and foreign sources and of
electronically supplied services under the section 250 regulations; (3)
the impact of the repeal of section 902 on certain regulations issued
under section 367(b); (4) the sourcing of inclusions under sections
951, 951A, and 1293; (5) the allocation and apportionment of interest
deductions of certain regulated utilities; (6) a revision to the
controlled foreign corporation (``CFC'') netting rule; (7) the
allocation and apportionment of section 818(f)(1) items of life
insurance companies that are members of consolidated groups; (8) the
allocation and apportionment of foreign income taxes, including taxes
imposed with respect to disregarded payments; (9) the definitions of a
foreign income tax and a tax in lieu of an income tax, including
changes to the net gain requirement, the replacement of the
jurisdictional nexus rule with an attribution rule contained in the net
gain requirement, the treatment of certain tax credits, the treatment
of foreign tax law elections for purposes of the noncompulsory payment
rules, and the substitution requirement under section 903; (10) the
allocation of the liability for foreign income taxes in connection with
certain mid-year transfers or reorganizations; (11) the foreign branch
category rules in Sec. 1.904-4(f); and (12) the time at which credits
for foreign income taxes can be claimed pursuant to sections 901(a) and
905(a).
This rulemaking finalizes, without substantive change, certain
provisions in the 2020 FTC proposed regulations with respect to which
the Treasury Department and IRS did not receive any comments. See
Sec. Sec. 1.164-2(d), 1.250(b)-1(c), 1.250(b)-5, 1.336-2(g)(3), 1.338-
9(d), 1.367(b)-2, 1.367(b)-3, 1.367(b)-4, 1.367(b)-7, 1.367(b)-10,
1.461-1, 1.861-3(d), 1.861-8(e)(4), 1.861-8(e)(8)(v), 1.861-9(g)(3),
1.861-10(e)(8)(v), 1.861-10(f), 1.901-1, 1.901-2(e)(4), 1.901-2(f),
1.904-4(b), 1.904-4(c), 1.904-6, 1.905-3, 1.954-1, 1.960-1, and 1.960-
2. These provisions are generally not discussed in this preamble.
No comments were received with respect to the transition rules
contained in the 2020 FTC proposed regulations to account for the
effect on loss accounts of net operating loss carrybacks to pre-2018
taxable years that are allowed under the Coronavirus Aid, Relief, and
Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020).
Section 1.904(f)-12(j) was finalized without
[[Page 277]]
change in TD 9956, published in the Federal Register (86 FR 52971) on
September 24, 2021.
Comments that do not pertain to the 2020 FTC proposed regulations,
or that are otherwise outside the scope of this rulemaking, are
generally not addressed in this preamble but may be considered in
connection with future guidance projects.
The rules contained in proposed Sec. 1.861-9(k) (election to
capitalize certain expenses in determining tax book value of assets),
Sec. 1.861-10(g) (requiring the direct allocation of interest expense
in the case of certain foreign banking branches), and Sec. Sec. 1.904-
4(e)(1)(ii) and 1.904-5(b)(2) (relating to the definition of financial
services income) are not finalized in this document. The Treasury
Department and the IRS are continuing to study the comments received in
connection with those provisions.
Summary of Comments and Explanation of Revisions
I. Disallowance of Foreign Tax Credit or Deduction for Foreign Income
Taxes Under Section 245A(d)
Proposed Sec. 1.245A(d)-1(a) generally provided that neither a
credit under section 901 nor a deduction is allowed for foreign income
taxes (as defined in Sec. 1.901-2(a)) paid or accrued by a domestic or
foreign corporation that are attributable to a specified distribution
or specified earnings and profits of a foreign corporation. The
proposed rule defined a specified distribution--in the case of a
distribution to a domestic corporation--as the portion of a dividend
for which a deduction under section 245A(a) is allowed, a hybrid
dividend, or a distribution of certain previously taxed earnings
(``PTEP'') related to section 245A(d) (``section 245A(d) PTEP''). In
the case of a distribution to another foreign corporation, a specified
distribution included the portion of the distribution attributable to
section 245A(d) PTEP, or a tiered hybrid dividend that gives rise to a
U.S. shareholder inclusion by reason of section 245A(e)(2) and Sec.
1.245A(e)-1(c)(1). Specified earnings and profits included the portion
of the earnings and profits of a foreign corporation that would give
rise to a specified distribution if an amount equal to the entire
earnings and profits of the foreign corporation were distributed.
Specified earnings and profits also included an amount equal to the
portion of a U.S. return of capital amount, as that term is defined in
Sec. 1.861-20(b), that is treated as arising in a section 245A
subgroup, after the application of the asset method in Sec. 1.861-9.
Proposed Sec. 1.245A(d)-1(a) relied upon the rules in Sec. 1.861-20
to associate gross income included in the foreign tax base (``foreign
gross income'') with these amounts and to allocate foreign income taxes
to the foreign gross income. The proposed regulations also included an
anti-avoidance rule to, for example, prevent taxpayers from using
successive foreign law distributions to inappropriately associate
withholding tax on the distributions with PTEP arising from inclusions
under sections 951(a) and 951A(a). See proposed Sec. 1.245A(d)-
1(b)(2). The Treasury Department and the IRS requested comments on
possible revisions to Sec. 1.861-20 to address these concerns,
including rules to require the maintenance of separate accounts that
would reflect the effect of foreign law transactions on the earnings
and profits of a foreign corporation. 85 FR at 72079.
A comment noted that proposed Sec. 1.245A(d)-1(a) explicitly
treated as specified earnings and profits the portion of a U.S. return
of capital amount that is deemed to arise pursuant to Sec. 1.861-
20(d)(3)(i) in a section 245A subgroup under the asset method of Sec.
1.861-9, yet did not explicitly treat any amount as specified earnings
and profits when the asset method of Sec. 1.861-9 applies under
proposed Sec. 1.861-20(d)(3)(v) to characterize a disregarded payment
that is a remittance as made from a section 245A subgroup. The comment
also expressed concerns that proposed Sec. 1.245A(d)-1 did not
adequately clarify the treatment of foreign tax imposed on a
distribution received by a domestic or foreign corporation with respect
to its interest in a partnership, or on the proceeds of a disposition
of such an interest.
The comment also noted the uncertainty in proposed Sec. 1.245A(d)-
1(a) over the use of the asset method of Sec. 1.861-9 to characterize
foreign taxable income of a CFC and apply the disallowance rules of
section 245A(d), including when a CFC receives a distribution that is a
U.S. return of capital amount. The comment stated that, if the U.S.
return of capital amount is treated as made from earnings in a section
245A subgroup of the distributing CFC, the disallowance under section
245A(d) of foreign taxes associated with the portion of the specified
earnings and profits attributable to tested income of the recipient CFC
not included by a United States shareholder has the inappropriate
effect of double-counting the inclusion percentage of section 960(d).
With respect to the anti-avoidance rule of proposed Sec.
1.245A(d)-1(b)(2), the comment acknowledged the need to address
successive foreign law distributions and discussed three alternative
approaches. One approach would revise Sec. 1.861-20(d)(2)(ii)(A) to
treat a foreign law distribution as made ratably out of all of a
foreign corporation's earnings and profits, including PTEP, if the
amount of its earnings and profits exceeds the foreign gross income
arising from the foreign law distribution. The second approach would
maintain separate E&P accounts to track the effect of foreign law
distributions; the comment viewed this option as overly complex and
burdensome. The third approach would maintain the anti-avoidance rule
of proposed Sec. 1.245A(d)-1(b)(2) and make no substantive changes to
the operative rules. The comment indicated that a flexible, well-
articulated anti-avoidance rule could be more effective at policing
attempts to avoid section 245A(d) than a series of potentially
manipulable mechanical rules.
The Treasury Department and the IRS agree that proposed Sec.
1.245A(d)-1 did not clearly describe the income under Federal income
tax law to which foreign gross income should be treated as
corresponding for purposes of allocating and apportioning foreign
income taxes under Sec. 1.860-20. This lack of clarity resulted in
uncertainty in determining the extent to which foreign income taxes on
a U.S. return of capital amount, which can arise in a variety of
transactions involving both stock and partnership interests, should be
treated as attributable to income of a foreign corporation that would
give rise to a deduction under section 245A(a) when distributed.
In response to these comments, Sec. 1.245A(d)-1(a) is revised to
eliminate references to specified distributions and specified earnings
and profits. Instead, Sec. 1.245A(d)-1(a) of the final regulations
provides that no credit or deduction is allowed for foreign income
taxes attributable to (1) ``section 245A(d) income'' of a domestic
corporation, a successor of a domestic corporation, or a foreign
corporation (see Sec. 1.245A(d)-1(a)(1)(i)-(ii) and (a)(2)), or (2)
``non-inclusion income'' of a foreign corporation (see Sec. 1.245A(d)-
1(a)(1)(iii)).
Section 245A(d) income means, in the case of a domestic
corporation, dividends or inclusions for which a deduction under
section 245A(a) is allowed, a distribution of section 245A(d) PTEP, and
hybrid dividends and inclusions related to tiered hybrid dividends
under section 245A(e). In the case of a successor of a domestic
corporation, section 245A(d) income
[[Page 278]]
means a distribution of section 245A(d) PTEP. In the case of a foreign
corporation, section 245A(d) income means an item of subpart F income
that gives rise to an inclusion for which a deduction under section
245A(a) is allowed, a tiered hybrid dividend, and a distribution of
section 245A(d) PTEP. Under Sec. 1.245A(d)-1(b)(1), foreign income
taxes are attributable to section 245A(d) income if the taxes are
allocated and apportioned under Sec. 1.861-20 to the statutory
grouping within each section 904 category (the ``section 245A(d) income
group'') to which section 245A(d) income is assigned.
Accordingly, the disallowance under Sec. 1.245A(d)-1(a) applies
not only to foreign income taxes that are paid or accrued with respect
to certain distributions and inclusions, but also to taxes paid or
accrued by reason of the receipt of a foreign law distribution with
respect to stock, a foreign law disposition, ownership of a reverse
hybrid, a foreign law inclusion regime, or the receipt of a disregarded
payment described in Sec. 1.861-20(d)(3)(v)(B), to the extent the
foreign income taxes are attributable to section 245A(d) income. The
disallowance also applies where a foreign corporation pays or accrues
foreign income taxes that are attributable to section 245A(d) income of
the foreign corporation, in which case such taxes are not eligible to
be deemed paid under section 960 in any taxable year. For example, the
disallowance applies to foreign income taxes paid or accrued by reason
of the receipt by the foreign corporation of a tiered hybrid dividend.
These revised rules ensure that Sec. 1.861-20, including the rules
of Sec. 1.861-20(d)(2) for allocating and apportioning foreign income
tax to a statutory or residual grouping in a year in which there is no
income for Federal income tax purposes in the grouping, apply
consistently to allocate and apportion foreign income taxes to the
section 245A(d) income group. The rules of Sec. 1.861-20(d)(3) apply
to determine the circumstances under which foreign gross income
included by reason of a dividend or other distribution with respect to
stock, a partnership distribution, a sale or exchange of stock, or a
sale or exchange of a partnership interest is assigned to the section
245A(d) income group.
Non-inclusion income is defined as income other than subpart F
income, tested income, or income described in section 245(a)(5),
without regard to section 245(a)(12), (items of income constituting
post-1986 undistributed U.S. earnings) of a foreign corporation.
Section 1.245A(d)-1(b)(2)(ii) attributes foreign income taxes to non-
inclusion income of a foreign corporation to the extent the foreign
income taxes are allocated and apportioned to the domestic
corporation's section 245A subgroup category of stock when applying
Sec. 1.861-20 for purposes of section 904 as the operative section.
The final rules also attribute foreign income taxes to the non-
inclusion income of a reverse hybrid or foreign law CFC to the extent
that they are allocated and apportioned to the non-inclusion income
group under Sec. 1.861-20. See Sec. 1.245A(d)-1(b)(2)(iii).
The disallowance under Sec. 1.245A(d)-1(a)(1)(iii) therefore
applies to foreign income taxes paid or accrued by a domestic
corporation that are attributable to non-inclusion income of a foreign
corporation in which the domestic corporation is a United States
shareholder. For example, paragraph (a)(1)(iii) applies to foreign
income taxes that a domestic corporation that is a United States
shareholder of a foreign corporation pays or accrues by reason of its
receipt from the foreign corporation of a distribution that is a U.S.
return of capital amount to the extent the foreign income taxes are
attributable to non-inclusion income of the foreign corporation. The
final regulations at Sec. 1.245A(d)-1(b)(2)(ii) clarify that this rule
extends to foreign income taxes the domestic corporation pays or
accrues by reason of a remittance, a distribution that is a U.S. return
of partnership basis amount, or a disposition that gives rise to a U.S.
return of capital amount or a U.S. return of partnership basis amount.
The disallowance under paragraph (a)(1)(iii) also applies to foreign
income taxes that a domestic corporation that is a United States
shareholder pays or accrues by reason of its ownership of a reverse
hybrid or foreign law CFC, to the extent the foreign income taxes are
attributable to non-inclusion income of the reverse hybrid or foreign
law CFC and not otherwise disallowed under paragraph (a)(1)(i) or (ii).
The proposed anti-avoidance rule in Sec. 1.245A(d)-1(b)(2) is
finalized without substantive change at Sec. 1.245A(d)-1(b)(3). While
revising Sec. 1.861-20(d)(2)(ii)(A) to treat a foreign law
distribution as made ratably out of all of a foreign corporation's
earnings and profits would be a potentially feasible alternative
approach, the Treasury Department and the IRS have determined that on
balance the anti-avoidance rule provides an appropriate framework and
the necessary flexibility to address section 245A(d) avoidance.
Finally, for the avoidance of doubt, the final regulations clarify
that section 245A(d) operates to deny the credit or deduction for
foreign taxes paid or accrued with respect to dividends for which a
domestic corporation could claim a deduction under section 245A,
regardless of whether the corporation claims the deduction on its
return. See Sec. 1.245A(d)-1(c)(19) and (21) (defining section 245A(d)
income and section 245A(d) PTEP). See also H.R. Rep. No. 115-466, at
600 (2017) (Conf. Rep.) (``No foreign tax credit or deduction is
allowed for any taxes paid or accrued with respect to any portion of a
distribution treated as a dividend that qualifies for the DRD.''); id.
at 598 (describing section 245A as ``an exemption for certain foreign
income by means of a 100-percent deduction'').
II. Section 250 Regulations--Definition of Electronically Supplied
Service
Section 1.250(b)-5 provides rules for determining whether a service
is provided to a person, or with respect to property, located outside
the United States and therefore gives rise to foreign-derived deduction
eligible income (``FDDEI service''). The rules identify specific
enumerated categories, including a category for general services
provided to either consumers or business recipients. For purposes of
determining whether such a general service constitutes a FDDEI service,
the rules require the location of the recipient to be identified.
The regulations contain special rules in Sec. 1.250(b)-5(d)(2) and
Sec. 1.250(b)-5(e)(2)(iii) for determining the location at which
``electronically supplied services'' are provided. Section 1.250(b)-
5(c)(5) defines the term ``electronically supplied service'' to mean a
general service (other than an advertising service) that is delivered
primarily over the internet or an electronic network, and provides that
such services include cloud computing and digital streaming services.
Proposed Sec. 1.250(b)-5(c)(5) revised that definition to clarify
that, to qualify as an electronically supplied service, the value of
the service to the end user must be derived primarily from the
service's automation and electronic delivery and would not include, for
example, legal, accounting, medical or teaching services ``delivered
electronically and synchronously.'' No comments were received on the
proposed revised definition of an electronically supplied service.
By providing the example of professional or teaching services
provided in real time (synchronously) as not constituting
electronically supplied services, proposed Sec. 1.250(b)-5(c)(5) was
intended to illustrate cases where
[[Page 279]]
the primary value of the service was not in its automation and
electronic delivery. However, this example may have implied that the
temporal aspect of when the service is rendered, relative to when the
end user accesses that service, is a determinative factor in
constituting an ``electronically supplied service.'' The Treasury
Department and the IRS had intended that services accessed by an end
user outside of real time (asynchronously) also will not constitute an
``electronically supplied service'' if, under all the facts and
circumstances, they primarily involve human effort. Therefore, the
final regulations remove the reference to ``and synchronously'' from
the fourth sentence of Sec. 1.250(b)-5(c)(5) to clarify that the
definition does not depend on whether the services are rendered
synchronously or asynchronously but rather depend on whether the
services primarily involve human effort.
III. Allocation and Apportionment of Expenses Under Section 861
Regulations
A. Treatment of Section 818(f)(1) Items for Consolidated Groups
Proposed Sec. 1.861-14(h) provided that certain items of life
insurance companies described in section 818(f)(1) that are members of
a consolidated group are allocated and apportioned on a life subgroup
basis but provided a one-time election to allocate and apportion these
items on a separate company basis. The one comment received endorsed
the approach in the 2020 FTC proposed regulations, which are finalized
without change.
B. Allocation and Apportionment of Foreign Income Taxes
1. In General
The 2020 FTC proposed regulations provided more detailed and
comprehensive guidance regarding the assignment of foreign gross
income, and the allocation and apportionment of the associated foreign
income taxes, to the statutory and residual groupings in certain cases.
This guidance included rules for dispositions of stock and partnership
interests, and rules for transactions that are distributions with
respect to a partnership interest, under Federal income tax law. It
also included new rules addressing the allocation and apportionment of
foreign income taxes imposed by reason of disregarded payments.
2. Dispositions of Stock
Proposed Sec. 1.861-20(d)(3)(i)(D) provided that the foreign gross
income arising from a transaction that is treated as a sale, exchange,
or other disposition of stock for Federal income tax purposes is
assigned first to the statutory and residual groupings to which any
U.S. dividend amount is assigned under Federal income tax law, to the
extent thereof. Foreign gross income is next assigned to the grouping
to which the U.S. capital gain amount is assigned, to the extent
thereof. Any excess of the foreign gross income over the sum of the
U.S. dividend amount and the U.S. capital gain amount is assigned to
the statutory and residual groupings in the same proportions in which
the tax book value of the stock is (or would be if the taxpayer were a
United States person) assigned to the groupings under the rules of
Sec. 1.861-9(g) in the U.S. taxable year in which the disposition
occurs.
A comment recommended that, to the extent of any basis in the stock
attributable to a previous increase under section 961, foreign gross
income in excess of the U.S. dividend amount be assigned to the same
statutory grouping as the PTEP that gave rise to the basis increase.
The comment noted that assigning foreign gross income in excess of the
U.S. dividend amount to the grouping that produced the underlying PTEP
would better conform the tax attribution consequences of a disposition
of stock with the tax attribution consequences of a pre-sale
distribution with respect to the stock.
Under Sec. 1.861-20(d)(1), Federal income tax law applies to
characterize the transaction that gives rise to foreign gross income.
The sale of stock may result in a U.S. dividend amount, a U.S. return
of capital amount, and a U.S. capital gain amount for U.S. tax
purposes. As noted in the preamble to the 2020 FTC proposed
regulations, when a controlled foreign corporation has retained PTEP,
the usual consequence will be to increase the portion of the amount
realized on the sale of the corporation's stock that is treated as a
return of capital for U.S. tax purposes, as a result of the basis
adjustments under section 961. Accordingly, it is reasonable to
conceive of foreign gross income in the amount of the basis
attributable to retained PTEP as a timing difference associated with
the earnings represented by the PTEP, just as an amount of foreign
gross income equal to a section 1248 amount that is included in the
U.S. dividend amount is treated as a timing difference associated with
those non-previously taxed earnings.
However, the approach suggested in the comment would create an
additional compliance burden for taxpayers and administrative burdens
for the IRS by requiring the separate tracking of basis in the stock
attributable to a previous increase under section 961, which is not
otherwise required for U.S. tax purposes. Additional rules would be
required to associate PTEP with the particular shares of stock being
sold, such as in the case of a taxpayer with PTEP in different
statutory groupings who sells one class of stock but retains a
different class of stock. The Treasury Department and the IRS have
determined that the groupings to which the tax book value of the stock
is assigned is an administrable and reasonably accurate surrogate for
both the PTEP and the future, unrealized earnings of the corporation
with which the foreign gross income is properly associated when foreign
tax is imposed on a U.S. return of capital amount. For these reasons,
the final regulations retain the rule in proposed Sec. 1.861-
20(d)(3)(i)(D).
3. Partnership Transactions
Proposed Sec. 1.861-20(d)(3)(ii)(B) assigned foreign gross income
arising from a partnership distribution in excess of the U.S. capital
gain amount by reference to the asset apportionment percentages of the
tax book value of the partner's distributive share of the partnership's
assets (or, in the case of a limited partner with less than a 10
percent interest, the tax book value of the partnership interest),
which are a surrogate for the partner's distributive share of earnings
of the partnership that are not recognized in the year in which the
distribution is made for U.S. tax purposes. This approach is based on
principles similar to those underlying the rule in proposed Sec.
1.861-20(d)(3)(i)(D) for allocating and apportioning foreign tax
imposed on an amount that is a return of capital with respect to stock
for Federal income tax purposes. Similarly, the 2020 FTC proposed
regulations associated foreign gross income from the disposition of a
partnership interest in excess of the U.S. capital gain amount with a
hypothetical distributive share that is determined by reference to the
tax book value of the partnership's assets (or, in the case of a
limited partner with less than a 10 percent interest, the tax book
value of the partnership interest). See proposed Sec. 1.861-
20(d)(3)(ii)(C).
A comment recommended that, in the case of either a distribution
with respect to a partnership or a disposition of a partnership
interest, foreign gross income in excess of the U.S. capital gain
amount be characterized instead by reference to the statutory and
residual groupings of amounts maintained in partner-level accounts that
track the partners' distributive shares of
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partnership earnings in prior years. According to the comment, the tax
book value method potentially distorts the allocation of tax to U.S.
income items in cases in which the amount of income produced by the
asset is disproportionate to its basis. For this reason, the comment
recommended tracing foreign gross income to amounts in the partner's
cumulative distributive share account in order to provide for more
accurate matching of foreign gross income to partners' distributive
shares of partnership income for the current and prior years. The
comment recommended that these new partner-level accounts be increased
as a partner includes a distributive share of partnership income and
decreased as the partnership makes distributions. Under this multi-year
account approach, foreign gross income arising from partnership
distributions would be characterized by reference to the earnings in
the account out of which the distribution is made, and foreign gross
income arising from a disposition of a partnership interest would be
characterized by reference to the earnings in the account at the time
of disposition. In either case, additional rules (such as providing for
the use of a pro rata, last-in-first-out, or other approach) would be
required to determine the earnings in the account out of which a
distribution is considered to be made, and for cases in which the
amount in the partner-level account exceeds the foreign gross income
arising from a disposition of that partner's partnership interest.
Recognizing the additional record-keeping requirements and
complexity required by this approach, the comment suggested in the
alternative that foreign gross income in excess of a U.S. capital gain
amount recognized by reason of a partnership distribution or
disposition of a partnership interest be characterized based on the
partner's distributive share of the partnership's current year income,
to the extent thereof, with any excess assigned based on the tax book
value method provided for in the 2020 FTC proposed regulations.
The final regulations retain the approach from the 2020 FTC
proposed regulations for characterizing foreign gross income arising
from a partnership distribution or disposition. The Treasury Department
and the IRS do not agree that it is appropriate to treat a partnership
distribution as made out of a partner's distributive share of
partnership income. Contrary to the ordering rules that apply to
distributions by a corporation, under Federal income tax law
partnership distributions are not sourced from current or accumulated
partnership income. Similarly, under Federal income tax law, a
partnership distribution reduces a partner's basis in its partnership
interest without differentiating between basis from capital
contributions and basis from a partner's distributive share of
partnership income.
A common principle of the rules in Sec. 1.861-20 is that Federal
income tax law applies to characterize foreign gross income. To the
extent a partnership distribution or disposition is treated as a return
of basis for Federal income tax purposes, Sec. 1.861-20(d)(3)(ii)(B)
and (C) appropriately reflect this principle by allocating and
apportioning any foreign tax imposed on the partnership distribution in
the same manner as foreign tax on a return of capital with respect to
stock. Furthermore, this approach to characterizing foreign gross
income arising from a partnership distribution is consistent with the
approach in Sec. 1.861-20(d)(3)(v)(C)(1) that applies to a
distribution that is a remittance by a taxable unit.
As acknowledged by the comment, characterizing foreign gross income
by reference to a partner's distributive share of partnership income in
prior years would require creating new partner-level accounts to track
the partner's aggregate distributive share of unremitted partnership
income. That type of partner-level account is not otherwise required to
be maintained to characterize partnership distributions for Federal
income tax purposes and would be unduly burdensome for both taxpayers
and the IRS, as well as being generally inconsistent with the Federal
income tax rules for characterizing partnership distributions. In
addition, the Treasury Department and the IRS have determined that the
suggested alternative approach of characterizing foreign gross income
by reference to a partner's distributive share of current year
partnership income would be susceptible to manipulation by timing
partnership distributions to maximize foreign tax credit benefits.
Therefore, the comment is not adopted.
4. Disregarded Payments
The 2020 FTC proposed regulations addressed the allocation and
apportionment of foreign income taxes that are imposed by reason of a
disregarded payment between taxable units. In the case of foreign
income taxes paid or accrued by an individual or domestic corporation,
the rules defined a taxable unit as a foreign branch, foreign branch
owner, or non-branch taxable unit as defined in proposed Sec. 1.904-
6(b)(2)(i)(B). In the case of foreign income taxes paid by a foreign
corporation, the rules defined a taxable unit by reference to the
tested unit definition in proposed Sec. 1.954-1(d)(2), as contained in
proposed regulations (REG-127732-19) addressing the high-tax exception
under section 954(b)(4), published in the Federal Register (85 FR
44650) on July 23, 2020 (the ``2020 HTE proposed regulations''). See
proposed Sec. 1.861-20(d)(3)(v)(E)(9).
In general, the 2020 FTC proposed regulations characterized a
disregarded payment as either a payment out of the current income
attributable to a taxable unit (a ``reattribution payment''), a
contribution to a taxable unit, or a remittance out of accumulated
earnings of a taxable unit. See proposed Sec. 1.861-20(d)(3)(v). The
rules assigned foreign gross income arising from a reattribution
payment to the statutory and residual groupings of the recipient
taxable unit based on the groupings to which the current income out of
which the reattribution payment was made is assigned. See proposed
Sec. 1.861-20(d)(3)(v)(B). The rules assigned foreign gross income
arising from a contribution received by a taxable unit to the residual
grouping, and assigned foreign gross income arising from a remittance
by reference to the statutory and residual groupings to which the
assets of the payor taxable unit were assigned for purposes of
apportioning interest expense, which served as a proxy for the
accumulated earnings of the payor taxable unit. See proposed Sec.
1.861-20(d)(3)(v)(C). For this purpose, the assets of a payor taxable
unit were determined under the rules of Sec. 1.987-6(b), modified to
include in a taxable unit's assets any stock that it owned, and in
certain circumstances reattributed another taxable unit's assets to the
taxable unit or reattributed the taxable unit's assets to another
taxable unit. See proposed Sec. 1.861-20(d)(3)(v)(C)(1)(ii).
Comments criticized the tax book value method as an inaccurate
surrogate for accumulated earnings of a taxable unit in the case of an
asset with a basis that is disproportionate to the income produced by
the asset and requested that foreign gross income arising from a
remittance be assigned to the statutory and residual groupings based on
the current earnings of a taxable unit. In addition, comments requested
that, rather than trace foreign gross income arising from disregarded
payments to current or accumulated earnings of a taxable unit, the
definition of which generally includes disregarded entities, the rules
should only trace such foreign
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gross income to current or accumulated income of a qualified business
unit (``QBU'') to reduce the complexity and compliance burden of the
rules. Finally, a comment suggested that the modifications to the rules
of Sec. 1.987-6(b) for purposes of determining the assets of a taxable
unit should be expanded to include not only stock, but any interest of
a taxable unit in another taxable unit, including a partnership.
The Treasury Department and the IRS do not agree that current
earnings of a taxable unit, rather than the tax book value of its
assets, should be the basis for characterizing foreign gross income
included by reason of a remittance. The Treasury Department and the IRS
have determined that, although the tax book value of the assets of a
taxable unit may not be a perfect surrogate for the accumulated
earnings of that taxable unit, it is a better surrogate than current-
year earnings of the taxable unit. The use of current-year earnings is
rejected because the current-year earnings may already have been
accounted for through reattribution payments, may not reflect all of a
taxable unit's assets, and could be subject to manipulation through the
timing of disregarded payments, depending on the character of the
earnings attributed to a taxable unit for a particular taxable year.
Although a more accurate matching of foreign gross income to
accumulated income for Federal income tax purposes could be achieved
through the maintenance of multi-year accounts tracking accumulated
earnings of a taxable unit, characterizing the accumulated earnings of
a taxable unit by reference to the tax book value of its assets
appropriately balances concerns about administrability, compliance
burdens, manipulability, and accuracy.
The Treasury Department and the IRS do not agree that foreign gross
income should be traced to income only when disregarded payments are
made by a QBU, rather than a taxable unit. The purpose of this rule in
the 2020 FTC proposed regulations was to implement a tracing regime for
foreign income tax imposed on disregarded payments that more accurately
distinguished payments made out of current income from those made out
of accumulated income, rather than treating all disregarded payments as
either remittances or contributions. Tracing cannot achieve the policy
goal of improved accuracy in matching disregarded payments to the
current or accumulated earnings out of which the payment is made if it
does not fully account for all disregarded payments. Accordingly, this
recommendation is not adopted.
The Treasury Department and the IRS agree that for purposes of
Sec. 1.861-20 the assets of a taxable unit should include not only
stock that it owns, but also its interests in other taxable units.
Asset tax book values serve as a surrogate for the accumulated earnings
from which a taxable unit made a remittance; including a taxable unit's
interests in all other taxable units appropriately reflects all of the
income-producing assets of a taxable unit that could produce earnings.
Accordingly, Sec. 1.861-20(d)(3)(v)(C)(1)(ii) of the final regulations
provides that a taxable unit's assets include its pro rata share of the
assets of another taxable unit in which it owns an interest.
The definitions of the terms ``contribution'' and ``remittance'' in
Sec. 1.861-20(d)(3)(v)(E) of the final regulations are revised so
that, together, they describe all payments that are not reattribution
payments. The proposed regulations defined a ``contribution'' as a
transfer of property to a taxable unit that would be treated as a
contribution to capital described in section 118 or a transfer
described in section 351 if the taxable unit were a corporation under
Federal income tax law, or the excess of a disregarded payment made by
a taxable unit to another taxable unit that the first taxable unit owns
over the portion of the disregarded payment that is a reattribution
payment. The proposed regulations defined a ``remittance'' as a
transfer of property that would be treated as a distribution by a
corporation to a shareholder with respect to its stock if the taxable
unit were a corporation for Federal income tax law, or the excess of a
disregarded payment made by a taxable unit to a second taxable unit
over the portion of the disregarded payment that is a reattribution
payment, other than an amount treated as a contribution. The proposed
definition of ``contribution'' did not encompass a disregarded payment
that is neither a reattribution payment nor a transfer that would be
described in section 351, such as, in some circumstances, disregarded
interest payments. To fill this gap, Sec. 1.861-20(d)(3)(v)(E) of the
final regulations defines a ``contribution'' as the excess of a
disregarded payment made by a taxable unit to another taxable unit that
the first taxable unit owns over the portion of the disregarded
payment, if any, that is a reattribution payment. This definition
encompasses a transfer of property to a taxable unit that would be
treated as a contribution to capital described in section 118 or a
transfer described in section 351 if the taxable unit were a
corporation. In addition, Sec. 1.861-20(d)(3)(v)(E) of the final
regulations defines a ``remittance'' as a disregarded payment that is
neither a contribution nor a reattribution payment. This definition
encompasses a transfer of property that would be treated as a
distribution by a corporation to a shareholder with respect to its
stock if the taxable unit were a corporation. These changes ensure that
the final regulations provide rules for allocating foreign income taxes
attributable to all disregarded payments.
In addition, the final regulations define a ``taxable unit'' by
reference to the tested unit definition in Sec. 1.951A-2(c)(7)(iv)(A),
a final regulation, instead of by reference to the definition of a
taxable unit in proposed Sec. 1.954-1(d)(2). See Sec. 1.861-
20(d)(3)(v)(E)(9).
The final regulations provide a special rule at Sec. 1.861-
20(d)(3)(vi) for allocating and apportioning foreign income tax on
foreign gross income included by a taxpayer by reason of its ownership
of a U.S. equity hybrid instrument (defined in Sec. 1.861-20(b)(22) as
an instrument that is stock or a partnership interest under Federal
income tax law but that is debt or otherwise gives rise to the accrual
of income that is not treated as a dividend or a distributive share of
partnership income under foreign law). This special rule, which
generally allocates foreign income tax on foreign gross interest income
with respect to a U.S. equity hybrid instrument to the grouping to
which distributions with respect to the instrument are assigned,
clarifies how section 245A(d) and Sec. 1.245A(d)-1 apply to foreign
income tax that is attributable to a hybrid dividend. As discussed in
part I of this Summary of Comments and Explanation of Revisions, Sec.
1.245A(d)-1 relies upon the rules of Sec. 1.861-20 to determine
whether foreign income tax is attributable to income described in
section 245A, including a hybrid dividend described in section 245A(e),
in which case a credit or deduction for the foreign income tax is
disallowed.
Section 1.861-20(d)(3)(vi)(A) treats foreign gross income included
by reason of an accrual of income with respect to a U.S. equity hybrid
instrument as a distribution. Accordingly, it assigns the foreign gross
income to the statutory and residual groupings as though the accrual
were a foreign law distribution that was made on the date of the
accrual. Section 1.861-20(d)(3)(vi)(B) provides an identical rule for a
payment of interest under foreign law with respect to the U.S. equity
hybrid instrument; therefore, withholding tax on the payment is also
attributed to income (determined under Federal income tax law) from the
instrument.
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Finally, as part of finalizing the rules in Sec. 1.861-
20(d)(3)(v), conforming changes are made to Sec. 1.951A-2(c)(7) and
(8). In particular, Sec. 1.951A-2(c)(7)(iii)(B) is deleted and
Examples 1 and 3 in Sec. 1.951A-2(c)(8)(iii)(A) and (C) are revised
accordingly while Example 2 in Sec. 1.951A-2(c)(8)(iii)(B) is removed
as obsolete. Section 1.951A-2(c)(7)(iii)(B) is removed from the final
regulations because the special rules in that paragraph for allocating
and apportioning current year taxes imposed by reason of a disregarded
payment are rendered obsolete by the final rules in Sec. 1.861-
20(d)(3)(v). Under Sec. 1.951A-2(c)(7)(iii)(A), deductible expenses
(including expenses for current year taxes) are allocated and
apportioned under the principles of Sec. 1.960-1(d)(3) and the rules
in Sec. 1.861-20.
5. Applicability Date
Section 1.861-20 (other than Sec. 1.861-20(h)) applies to taxable
years that begin after December 31, 2019, and end on or after November
2, 2020. Section 1.861-20(h) applies to taxable years beginning on or
after December 28, 2021. In addition, the revisions to Sec. 1.951A-
2(c)(7) and (8) apply to taxable years that begin after December 28,
2021; however, taxpayers may choose to apply the final rules to taxable
years that begin after December 31, 2019, and on or before December 28,
2021, consistent with the applicability date of Sec. 1.861-
20(d)(3)(v).
Several comments asked the Treasury Department and the IRS to
provide a delayed applicability date for Sec. 1.861-20. The rules in
proposed Sec. 1.861-20 revised the corresponding provisions in the
2019 FTC proposed regulations, which were not finalized with the 2020
FTC final regulations to provide an additional opportunity for comment.
Because the regulations are finalized substantially as proposed, with
primarily clarifying changes in response to comments, the Treasury
Department and the IRS have determined that it is not appropriate to
modify the proposed applicability date.
IV. Creditability of Foreign Taxes Under Sections 901 and 903
A. Jurisdictional Nexus Requirement
1. In General
The 2020 FTC proposed regulations added a jurisdictional nexus
requirement for determining whether a foreign tax qualifies as a
foreign income tax for purposes of section 901. Proposed Sec. 1.901-
2(a)(3) and (c) generally required that, for a foreign tax to be a
foreign income tax, the foreign country imposing the tax must have
sufficient nexus to the taxpayer's activities or investment of capital
or other assets that give rise to the income base on which the foreign
tax is imposed. In the case of a foreign tax imposed by a foreign
country on nonresident taxpayers, the 2020 FTC proposed regulations
provided that a foreign tax satisfies the jurisdictional nexus
requirement if it meets one of three nexus tests.
First, under proposed Sec. 1.901-2(c)(1)(i), a foreign tax meets
the jurisdictional nexus requirement if it is imposed only on income
that is attributable, under reasonable principles, to the nonresident's
activities located in the foreign country (for this purpose, the
nonresident's activities include its functions, assets, and risks)
(``activities-based nexus''). To meet the activities-based nexus test,
the allocation of a nonresident's income to the nonresident's
activities in the foreign country cannot take into account, as a
significant factor, the location of customers, users, or any similar
destination-based criterion. Proposed Sec. 1.901-2(c)(1)(i) further
provided that reasonable principles for determining income attributable
to a nonresident's activities include rules similar to those for
determining effectively connected income under section 864(c).
Second, under proposed Sec. 1.901-2(c)(1)(ii), a foreign tax
imposed on the nonresident's income arising in the foreign country
meets the jurisdictional nexus requirement only if the foreign tax law
sourcing rules are reasonably similar to the sourcing rules that apply
for Federal income tax purposes (``source-based nexus'').
Third, under proposed Sec. 1.901-2(c)(1)(iii), a foreign tax
imposed on income or gain from sales or other dispositions of property
that is subject to tax in the foreign country on the basis of the situs
of real or movable property meets the jurisdictional nexus requirement
only if it is imposed with respect to income or gain from the
disposition of real property situated in the foreign country or movable
property forming part of the business property of a taxable presence in
the foreign country (or from interests in certain entities holding such
property) (``property-based nexus'').
In the case of a foreign tax imposed by a foreign country on its
residents, proposed Sec. 1.901-2(c)(2) provided that in determining
whether the foreign tax meets the jurisdictional nexus requirement, any
allocation of income, gain, deduction or loss between a resident
taxpayer and a related or controlled entity under the foreign country's
transfer pricing rules must follow arm's length principles, without
taking into account as a significant factor the location of customers,
users, or any other similar destination-based criterion.
Under the 2020 FTC proposed regulations, the jurisdictional nexus
requirement also applied to determine whether a foreign levy is a tax
in lieu of an income tax under section 903 (an ``in lieu of tax'').
Specifically, the 2020 FTC proposed regulations modified the
substitution requirement to add proposed Sec. 1.903-1(c)(1)(iv), which
required that the generally-imposed net income tax would either
continue to qualify as a net income tax under proposed Sec. 1.901-
2(a)(3), or would itself constitute a separate levy that is a net
income tax if it were to be imposed on the excluded income that is
covered by the tested in lieu of tax. This modification was intended to
ensure that a foreign tax can qualify as an in lieu of tax only if the
foreign country imposing the tax could instead have subjected the
excluded income to a tax on net gain that would satisfy the
jurisdictional nexus requirement in proposed Sec. 1.901-2(c). In
addition, proposed Sec. 1.903-1(c)(2)(iii) provided that, to satisfy
the substitution requirement, a withholding tax must meet the source-
based jurisdictional nexus requirement in proposed Sec. 1.901-
2(c)(1)(ii) to qualify as a ``covered withholding tax.'' Comments
regarding the jurisdictional nexus test of the substitution requirement
are discussed in this part IV.A of this Summary of Comments and
Explanation of Revisions; other comments regarding the proposed
modifications to the in lieu of tax provisions are discussed in part
IV.C of this Summary of Comments and Explanation of Revisions.
2. Reasonableness of Jurisdictional Nexus Requirement
i. Text and History of the Relevant Statutory Provisions
a. Income Tax in the U.S. Sense
Comments questioned the validity of the jurisdictional nexus
requirement, stating that the requirement is inconsistent with the
plain language, structure, and legislative history of the statutory
foreign tax credit provisions. Comments stated that the plain meaning
of ``income tax'' refers solely to whether the base of the tax is net
income and does not require a justification (nexus) for the imposition
of the tax. Some comments stated that the term ``income tax'' should
not be interpreted to encompass U.S. rules or international norms
regarding jurisdiction to tax
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because, according to those comments, when the foreign tax credit
provisions were first enacted there were limited source rules in the
Code and international norms for determining the source of income were
still developing. Other comments stated that the inclusion of a
jurisdictional nexus requirement would require Congressional action and
noted that other exceptions to creditability have been enacted by
Congress (see, for example, section 901(f), (i) and (m)). Some comments
stated that the Supreme Court in Biddle v. Comm'r, 302 U.S. 573 (1938),
made only a passing reference to ``an income tax in the U.S. sense,''
and that neither Biddle nor any other case has interpreted the statute
to include a jurisdictional nexus requirement.
The Treasury Department and the IRS have determined that the
addition of a jurisdictional nexus requirement is a valid exercise of
the government's rulemaking authority. The Treasury Department and the
IRS have determined that it is reasonable and appropriate to interpret
the terms ``income tax'' and ``tax in lieu of an income tax'' in
sections 901 and 903, respectively, to incorporate a jurisdictional
nexus requirement. Judicial decisions and administrative guidance over
the past century have interpreted the term ``income, war profits, and
excess profits tax,'' which is not defined in section 901 or by the
limited initial explanation in the early legislative history. These
interpretations have consistently followed the principle, introduced by
the Biddle court, that the determination of whether a foreign tax is
creditable under section 901 is made by evaluating whether such tax, if
enacted in the United States, would be an income tax (in other words,
whether the foreign tax is ``an income tax in the U.S. sense''). See
PPL Corp. v. Comm'r, 569 U.S. 329, 335 (2013). See also Inland Steel
Co. v. United States, 230 Ct. Cl. 314, 325 (1982) (``Whether a foreign
tax is an income tax under I.R.C. Sec. 901(b)(1) is to be decided
under criteria established by United States revenue laws and court
decisions.''). It is well-settled that U.S. tax provisions should
generally be interpreted with reference to domestic tax concepts absent
a clear Congressional expression that foreign concepts control. United
States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 145 (1989). The
jurisdictional nexus requirement is consistent with the principle that
U.S. tax principles, not varying foreign tax law policies, should
control the determination of whether a foreign tax is an income tax (or
a tax in lieu of an income tax) that is eligible for a U.S. foreign tax
credit.
U.S. tax law has long incorporated a jurisdictional nexus
limitation in taxing income of foreign persons. For example, the United
States only taxes income of foreign persons that have income that is
effectively connected with a U.S. trade or business or attributable to
U.S. real property, or have income that is fixed or determinable,
annual or periodic (FDAP) income sourced in the United States. See
sections 871, 881, 882, and 897. In addition, U.S. foreign tax credit
rules reflect international norms of taxing jurisdiction that assign
the primary right to tax to the source country, the secondary right to
tax to the country where the taxpayer is a resident or engaged in a
trade or business, and the residual right to tax to the country of
citizenship or place of incorporation. See sections 904(a) (limiting
foreign tax credits to U.S. tax on foreign source income) and 906(b)(1)
(limiting foreign tax credits allowed to foreign persons engaged in a
U.S. trade or business to foreign taxes on foreign source effectively
connected income). In keeping with these traditional U.S. taxing rules,
international taxing norms (such as provisions included in the OECD
Model Tax Convention), and the longstanding approach of the courts to
apply U.S. tax principles in determining whether a foreign tax is an
income tax in the U.S. sense, it is appropriate for the definition of a
creditable tax to incorporate the concept of jurisdictional nexus from
the U.S. tax law. The fact that U.S. tax rules have changed since the
foreign tax credit provisions were first enacted does not preclude an
interpretation of the term ``income tax'' to reflect U.S. norms,
because the principle of ``an income tax in the U.S. sense''
incorporates an evolving standard of what constitutes an income tax in
the U.S. sense.
In addition, the net gain requirement in existing Sec. 1.901-2(b),
which prescribes the elements of gross receipts and costs that must
comprise the base of a foreign income tax, has historically reflected
jurisdictional norms in limiting creditable taxes to those imposed on
net income. The jurisdictional nexus requirement clarifies the limits
on the scope of the items of gross receipts and costs that may properly
be taken into account in computing the taxable base of a creditable
foreign income tax. Absent this rule, U.S. tax on net income could be
reduced by credits for a foreign levy whose taxable base was improperly
inflated by unreasonably assigning income to a taxpayer, or by not
appropriately taking into account significant costs that are
attributable to gross receipts properly included in the taxable base.
Existing Sec. 1.901-2(b)(4)(i)(A) has long contained a form of a
nexus rule, by requiring recovery of significant costs and expenses
that are ``attributable, under reasonable principles'' to gross
receipts included in the foreign tax base. A rule providing the extent
to which gross receipts and costs are within the scope of a
jurisdiction's right to tax is therefore necessary to determine which
items of gross receipts and costs a foreign levy must include to
satisfy the net gain rules.
To better reflect the role of the jurisdictional nexus rule as an
element of the net gain requirement, the rule in proposed Sec. 1.901-
2(c) is incorporated in the net gain requirement as new paragraph Sec.
1.901-2(b)(5). In addition, the term ``jurisdictional nexus
requirement'' is replaced with ``attribution requirement'' to more
clearly reflect that the rule provides limits on the scope of gross
receipts and costs that are attributable to a taxpayer's activities and
thus appropriately included in the foreign tax base for purposes of
applying the other components of the net gain requirement.
b. Relationship to Foreign Tax Credit Limitation
Some comments asserted that Congress explicitly removed a
jurisdictional nexus requirement from the predecessor to section 901 in
1921, and since then, Congress has addressed concerns regarding
jurisdiction to tax through the foreign tax credit limitation under
section 904 (and its predecessor provisions). The comments pointed out
that the foreign tax credit provision, when first enacted under the
Revenue Act of 1918, provided that U.S. tax was ``credited with . . .
the amount of any income, war-profits and excess-profits taxes paid
during the taxable year to any foreign country, upon income derived
from sources therein, or to any possession of the United States.''
Public Law 65-254, Sec. 222(a)(1) and 238(a), 40 Stat. 1057, 1073,
1080-81 (emphasis added). The comments stated that the phrase ``upon
income derived from sources therein'' served as a jurisdictional nexus
limit, which Congress eliminated and replaced by enacting the foreign
tax credit limitation in the Revenue Act of 1921. The comments asserted
that this legislative history shows that Congress has rejected
including a jurisdictional nexus requirement in section 901. The
comments also stated that the only concern regarding jurisdiction to
tax
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discussed in the legislative history to the 1918 and 1921 Revenue Acts
was Congress' desire to preserve U.S. primary taxing rights over U.S.
source income.
The Treasury Department and the IRS disagree with the comments'
conclusion that Congress has expressly rejected a jurisdictional nexus
requirement for creditable foreign taxes. Although source-based taxing
rights are an appropriate element of jurisdictional nexus, tax
residence and conducting business in a foreign country also provide
jurisdictional nexus. The Treasury Department and the IRS view the
introduction of the foreign tax credit limitation in 1921 as merely
refining the 1918 Revenue Act's limitation of credits to tax imposed
upon foreign source income. The legislative history does not explain
why Congress removed the phrase ``upon income from sources therein'' in
1921, nor does it suggest that Congress believed it was removing a
jurisdictional nexus requirement and replacing it with a foreign tax
credit limitation.
The Treasury Department and the IRS also disagree with the
comments' assertion that statutory policy regarding jurisdiction to tax
is confined to the section 904 foreign tax credit limitation. Congress
has not explicitly addressed jurisdictional nexus with respect to the
foreign tax credit. There is no statutory provision that addresses
whether the foreign tax credit should be allowed for taxes imposed
outside of traditional U.S. taxing norms. Section 904 does not address
the threshold question of whether a foreign tax is an income tax in the
U.S. sense. It only limits the allowable credit to the amount of pre-
credit U.S. tax on particular categories of foreign source income, as
revised by Congress from time to time. The foreign tax credit
limitation preserves residual U.S. tax on foreign source income subject
to a foreign rate of tax that is lower than the U.S. rate, but does not
ensure that the foreign tax has an appropriate jurisdictional basis.
The statute is silent with respect to jurisdictional nexus, and it is
reasonable and appropriate for regulations to apply U.S. tax concepts
in addressing the creditability of extraterritorial foreign levies that
Congress could not have anticipated when the foreign tax credit
provisions were first enacted.
c. Legislative Re-Enactment Doctrine
Some comments argued that the addition of a jurisdictional nexus
requirement is precluded by the legislative re-enactment doctrine.
These comments noted that the 1980 temporary and proposed section 901
regulations, which contained similar nexus requirements, drew numerous
adverse comments and were the subject of Congressional hearings, and
that the Treasury Department and the IRS did not finalize those
provisions in TD 7918 (48 FR 46276) (``the 1983 regulations''). These
comments asserted that in passing the Tax Reform Act of 1986, Public
Law 99-514, 100 Stat. 2085 (1986), and the Tax Cuts and Jobs Act,
Public Law 115-97, 131 Stat 2054 (2017) (``TCJA''), Congress was aware
of the 1983 regulations (which do not contain a jurisdictional nexus
requirement) and did not amend the statute to add one, with the result
that Congress implicitly endorsed the 1983 regulations and precluded
the Treasury Department and the IRS from modifying them.
The Treasury Department and the IRS disagree with these comments.
The legislative re-enactment doctrine does not preclude an agency from
changing its regulatory interpretation of a statute if Congress amends
related provisions. See Helvering v. Reynolds, 313 U.S. 428, 432 (1941)
(``[The doctrine of legislative reenactment] does not mean that the
prior construction has become so imbedded in the law that only Congress
can effect a change.''). See also Helvering v. Wilshire Oil Co., 308
U.S. 90, 100 (1939) (holding that the legislative reenactment doctrine
applies where ``it does not appear that the rule or practice has been
changed by the administrative agency through exercise of its continuing
rule-making power''); McCoy v. U.S., 802 F.2d 762 (4th Cir. 1986);
Interstate Drop Forge Co. v. Com., 326 F2d 743 (7th Cir. 1964).
Additionally, while a purported legislative re-enactment may
indicate that Congress was aware of, and implicitly endorsed, the prior
regulatory interpretation, a regulation or administrative ruling
promulgated under a re-enacted statute is not treated as binding unless
other evidence clearly manifests such a purpose. See Oklahoma Tax Com.
v. Texas Co., 336 U.S. 342 (1949); Jones v. Liberty Glass Co., 332 U.S.
524 (1947). There is no indication that Congress intended to preclude
the amendment of the section 901 and 903 regulations to add a
jurisdictional nexus requirement. None of the comments identified any
aspect of either the Tax Reform Act of 1986 or the TCJA that suggests
that Congress intended to limit future regulations addressing the
definition of creditable foreign taxes under sections 901 and 903.
Therefore, the Treasury Department and the IRS have determined that the
legislative re-enactment doctrine does not preclude the adoption of
prospective regulations that include a jurisdictional nexus
requirement.
ii. Policy and Purpose of the Statutory Foreign Tax Credit Provisions
Comments stated that adding a jurisdictional nexus requirement is
contrary to the policy of the foreign tax credit, which is to mitigate
double taxation of foreign source income. These comments asserted that
double taxation results when the United States imposes tax on income
that is taxed by another country, regardless of whether the other
country had a proper jurisdictional basis for imposing the tax, and
unrelieved double taxation could discourage foreign investment. The
comments asserted that Congress enacted the foreign tax credit to
enhance the competitiveness of American companies operating abroad, and
the jurisdictional nexus requirement in the 2020 FTC proposed
regulations would impede this competitiveness. The comments asserted
that the policy goal of sections 901 and 903 is not to influence
international norms or change the behavior of foreign governments.
However, another comment stated that the jurisdictional nexus
requirement may reasonably be viewed as consistent with the underlying
principles and purposes of the foreign tax credit regime. This comment
asserted that the allowance of a foreign tax credit for a tax levied on
amounts that do not have a significant connection to the foreign
jurisdiction taxing such income, particularly U.S. source income, could
effectively convert the foreign tax credit regime into a means of
subsidizing foreign jurisdictions at the expense of the U.S. fisc.
Similarly, one comment that questioned the government's authority to
include a jurisdictional nexus requirement also acknowledged that taxes
that have no nexus whatsoever to the taxing jurisdiction would not
properly be considered taxes.
The Treasury Department and the IRS agree with the comment that the
jurisdictional nexus requirement is consistent with the policy goals of
the foreign tax credit. The foreign tax credit is not intended to
subsidize foreign jurisdictions at the expense of the U.S. fisc. The
legislative history to the predecessor provisions to section 901, as
well as subsequent statutory amendments, reflect Congress' consistent
concern that foreign tax credits should not be allowed to offset U.S.
tax on income that does not have a significant connection to the
foreign jurisdiction taxing such income. See, for example, S. Rep. No.
67-275, at 17 (1921) (describing the need to avoid
[[Page 285]]
allowing a foreign tax credit to ``wipe out'' tax properly attributable
to U.S. source income); Senate Comm. on Finance, 98th Cong., 2d Sess.,
Deficit Reduction Act of 1984, Explanation of Provisions Approved by
the Committee on March 21, 1984, at 392 (Comm. Print 1984) (describing
the need for separate foreign tax credit limitation categories to
prevent the U.S. Treasury from inappropriately ``bear[ing] the burden''
of foreign taxes).
The 2020 FTC proposed regulations are also consistent with the
statutory purpose of the foreign tax credit to relieve double taxation
of income through the United States ceding its own taxing rights only
where the foreign country has the primary right to tax income. See
Bowring v. Comm'r, 27 B.T.A. 449, 459 (1932) (``In the case of the
citizen and resident alien, the United States recognizes the primary
right of the foreign government to tax income from sources therein . .
. and accordingly, grants a credit.''). To ensure that the United
States provides a foreign tax credit only where the foreign country
appropriately asserts jurisdiction to tax income, creditable foreign
levies must incorporate norms similar to those in U.S. tax law that
limit the scope of income subject to the tax.
Some comments asserted that double taxation meriting relief exists
in every case in which a foreign tax is not allowed as a foreign tax
credit against U.S. tax. However, that assertion is inconsistent not
only with the foreign tax credit limitation in section 904, but with
the plain text of section 901. Section 901 allows a credit only for
income, war profits, and excess profits taxes, and not for all foreign
taxes that may be imposed by a foreign jurisdiction (such as value
added taxes or sales taxes, which may qualify for a deduction under
section 164), or for other levies such as tariffs. As explained in part
IV.A.2.i.a of this Summary of Comments and Explanation of Revisions,
determining which items of gross receipts and costs are properly
included in a foreign taxable base is inherent to the determination of
whether the foreign tax is an income tax in the U.S. sense.
As noted in the preamble to the 2020 FTC proposed regulations, the
fundamental purpose of the foreign tax credit--to mitigate double
taxation with respect to taxes imposed on income--is served most
appropriately if there is substantial conformity in the principles used
to calculate the base of the foreign tax and the base of the U.S.
income tax. This conformity extends not just to ascertaining whether
the foreign tax base approximates U.S. taxable income determined on the
basis of realized gross receipts reduced by allocable costs and
expenses, but also to whether there is a sufficient nexus between the
income that is subject to tax and the foreign jurisdiction imposing the
tax. Therefore, the final regulations retain the requirement in the
2020 FTC proposed regulations that for a foreign tax to qualify as an
income tax, the tax must conform with established international
jurisdictional norms, reflected in the Internal Revenue Code and
related guidance, for allocating profit between associated enterprises,
for allocating business profits of nonresidents to a taxable presence
in the foreign country, and for taxing cross-border income based on
source or the situs of property.
Recently, many foreign jurisdictions have disregarded international
taxing norms to claim additional tax revenue, resulting in the adoption
of novel extraterritorial taxes that diverge in significant respects
from U.S. tax rules and traditional norms of international taxing
jurisdiction. These extraterritorial assertions of taxing authority
often target digital services, where countries seeking additional
revenue have chosen to abandon international norms to assert taxing
rights over digital service providers.\1\
---------------------------------------------------------------------------
\1\ See OECD Inclusive Framework on BEPS, Tax Challenges Arising
from Digitalisation--Report on Pillar One Blueprint, at 10 (Oct. 14,
2020) (``Globalisation and digitalisation have challenged
fundamental features of the international income tax system, such as
the traditional notions of permanent establishment and the arm's
length principle (ALP), and brought to the fore the need for higher
levels of enhanced tax certainty through more extensive multilateral
tax co-operation. These transformational developments have taken
place against a background of increasing public attention on the
taxation of highly digitalised global businesses.'').
---------------------------------------------------------------------------
The Treasury Department and the IRS have determined that it is
necessary and appropriate to adapt the regulations under sections 901
and 903 to address this change in circumstances, especially in relation
to the taxation of the digital economy--a sector that did not exist
when the foreign tax credit provisions were first enacted. Accordingly,
regulations are necessary and appropriate to more clearly delineate the
circumstances in which a tax does not qualify as an income tax in the
U.S. sense due to the foreign jurisdiction's unreasonable assertion of
jurisdictional taxing authority.
Some comments asserted that the jurisdictional nexus requirement in
the 2020 FTC proposed regulations is inconsistent with Congressional
policy reflected in the repeal of the per-country foreign tax credit
limitation in favor of an overall foreign tax credit limitation. These
comments suggested that the proposed jurisdictional nexus requirement
would effectively revert to the more limited per-country limitation
and, more generally, that the repeal of the per-country limitation
reflects a general policy favoring broader availability of foreign tax
credits. The Treasury Department and the IRS disagree with these
comments. The jurisdictional nexus requirement does not prevent cross-
crediting within a particular separate category described in section
904, which has been amended numerous times by Congress. For example,
the nexus requirement does not preclude a foreign tax credit against
U.S. tax on foreign source general category income derived from one
country for a foreign tax imposed by another country that is assigned
to the general category, whereas under the former per-country
limitation, such cross-crediting would not be allowed.
Additionally, while comments frame the per-country limitation as
more restrictive than the overall limitation, the debate concerning the
limitation also highlighted circumstances in which the overall
limitation is in fact the more restrictive of the two.\2\ In 1960, when
adding back the overall limitation, but retaining the per-country
limitation, Congress explained that the overall limitation may not be
appropriate based on the business model of a particular taxpayer. See
S. Rep. No. 86-1393, at 3773-74 (1960). Thus, the Treasury Department
and the IRS do not agree with the comments' assertion that Congress'
choice in 1976 to retain only the overall limitation supports the
broadest allowance of foreign tax credits, because either the per-
country or overall limitation may more significantly restrict the
amount of foreign tax credit, depending on the circumstances of a
particular taxpayer.
---------------------------------------------------------------------------
\2\ For example, both houses of Congress, in retreating from the
overall limitation in 1954, explained that ``[t]he effect of the
[overall] limitation is unfortunate because it discourages a company
operating profitably in one foreign country from going into another
country where it may expect to operate at a loss for a few years.
Consequently your committee has removed the overall limitation.''
H.R. Rep. No. 83-1337, at 4103 (1954); see also S. Rep. No. 83-1622,
at 4739 (1954).
---------------------------------------------------------------------------
Similarly, the choice in 1976 to add back the overall limitation
and make it the only limitation did not represent Congress's definitive
choice to allow unlimited cross-crediting of high-rate foreign taxes
against U.S. tax on foreign source income subject to a lower rate of
foreign tax. S. Rep. No. 86-1393, at 3773-74. Rather, Congress has
continually amended and debated the appropriate scope of the foreign
tax
[[Page 286]]
credit limitation since 1962. The ongoing Congressional amendments to
the foreign tax credit limitation show that Congress had not
definitively resolved the permissible scope of cross-crediting when it
enacted the predecessor provision to section 901.
In addition, Congress did not repeal the per-country limitation in
1976 primarily as a policy choice to allow cross-crediting. Rather,
Congress repealed the per-country limitation because it allowed a
taxpayer to reduce U.S. tax on U.S. source income by application of a
foreign source loss, and later to reduce U.S. tax on foreign source
income through a foreign tax credit. See S. Rep. No. 94-938, at 236
(1976); H.R. Rep. No. 94-658, at 225 (1975); Joint Comm. on Taxation,
General Explanation of the Tax Reform Act of 1976, at 236 (1976). In
conclusion, the comments' claim that the jurisdictional nexus
requirement in the 2020 FTC proposed regulations is inconsistent with
the Congressional policy reflected in the repeal of the per-country
limitation is not supported by the legislative history and is
contradicted by subsequent amendments to section 904.
Comments also stated that section 904(d)(2)(H)(i), which provides a
rule for assigning to a separate category foreign tax imposed by a
foreign country on an amount that does not constitute income under U.S.
tax principles, provides further support for the view that foreign tax
credit provisions should be construed broadly, with limited reference
to U.S. rules. One comment pointed to cases, including Schering Corp.
v. Comm'r, 69 T.C. 579 (1978) and Helvering v. Campbell, 139 F.2d 865
(1944), in which courts allowed a credit for foreign taxes on amounts
that the U.S. does not tax due to timing or base differences, for
example, as a result of characterization differences.
The Treasury Department and the IRS find these comments
unpersuasive, because the jurisdictional nexus requirement in the 2020
FTC proposed regulations would not preclude a credit for foreign taxes
imposed on an amount of taxable income that exceeds taxable income
computed under U.S. tax law rules due to base or timing differences.
The nexus rule requires that the activity subject to the tax have
sufficient connection to the foreign country imposing the tax. It does
not require that every item included in the foreign tax base conform in
timing or amount to items included in U.S. taxable income. Consistent
with section 904(d)(2)(H)(i), the jurisdictional nexus requirement in
the 2020 FTC proposed regulations does not preclude a credit for
foreign income taxes imposed on base difference amounts.
3. Other Policy Considerations
Several comments questioned the policy reasons discussed in the
preamble to the 2020 FTC proposed regulations that motivated the
Treasury Department and the IRS to add the jurisdictional nexus
requirement. Comments disagreed with the notion that destination-based
taxing rights lack sufficient connection to a jurisdiction. They noted
that Congress's deliberations of alternative approaches to the U.S.
corporate income tax and the current multilateral negotiations by the
OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting
(``Inclusive Framework'') with respect to reallocating taxing rights
under the ``Pillar 1'' proposal demonstrate that there is a legitimate
debate about claims to destination-based taxing rights. This ongoing
debate, the comments stated, indicates that market-based or
destination-based taxes are income taxes. As such, some comments
asserted that the jurisdictional nexus rule in the 2020 FTC proposed
regulations is inconsistent with changes that have occurred in how
income can be generated through technology and changes that various
taxing jurisdictions, including U.S. states, have made to their taxing
regimes in response to those changes. The comments recommended that if
the jurisdictional nexus requirement is not eliminated in the final
regulations, the requirement should be modified such that it is more
flexible and takes into account evolving jurisdictional norms. One
comment asked that the requirement be expansive enough to allow credits
for taxes imposed on income sourced to a jurisdiction based on the
situs of users or customers, as well as taxes imposed on a taxpayer
that generates income from customers in a jurisdiction without having a
physical presence in that jurisdiction.
One comment pointed out that U.S. income tax principles incorporate
destination-based taxing rights. As an example, the comment noted that
proposed Sec. 1.861-18(f)(2)(ii) provided that when a copyrighted
article is sold and transferred through an electronic medium, the sale
is deemed to have occurred at the location of download or installation
onto the end-user's device. As another example, the comment cited Sec.
1.250(b)-4(d)(1)(ii)(D), which provides that a sale of certain property
that primarily contains digital content is for a foreign use if the end
user downloads, installs, receives, or accesses the purchased digital
content on the end user's device outside the United States. Another
comment noted that Congress considered imposing a destination-based
income tax as part of the 2017 tax reform.
In addition, comments stated that over half of U.S. states with a
corporate income tax determine the amount of a taxpayer's income
subject to the state's corporate income tax by apportioning the
taxpayer's federal taxable income using sales as the single factor. The
comments stated that under the proposed jurisdictional nexus
requirements, these state income taxes would fail to be an ``income
tax'' in the U.S. sense even though the income subject to the state
corporate income taxes is based in significant respects on the
taxpayer's taxable income determined under the Code. The comments also
questioned whether this policy means that a foreign country can deny a
foreign tax credit for otherwise eligible U.S. state corporate income
taxes simply because the states rely on sales-based apportionment
factors to source income and a market-based jurisdictional nexus
standard.
In general, the Treasury Department and the IRS disagree with these
comments. As explained in part IV.A.2 of this Summary of Comments and
Explanation of Revisions, whether a foreign tax is creditable under
section 901 depends on whether the tax is an ``income tax in the U.S.
sense.'' Neither prior unenacted legislative proposals nor potential
future (yet undetermined) changes to the Code with respect to U.S.
jurisdictional limits are determinative of what constitutes an income
tax in the U.S. sense under current law.
The Treasury Department and the IRS acknowledged in the preamble to
the 2020 FTC proposed regulations that future changes in U.S. law may
necessitate rethinking the rules for determining creditable foreign
income taxes. It is nevertheless important that these final regulations
be issued promptly to address novel extraterritorial taxes. Existing
law is unclear on the extent to which foreign taxes that are
inconsistent with existing jurisdictional norms meet the definition of
an income tax under section 901, and the Treasury Department and the
IRS had previously received comments requesting guidance on this
matter.\3\ In addition, to the extent these novel extraterritorial
taxes, which many foreign jurisdictions have already adopted, are being
paid by taxpayers
[[Page 287]]
and claimed as a foreign tax credit, this would have an immediate and
detrimental impact on the U.S. fisc. Therefore, the Treasury Department
and the IRS disagree with the suggestion in comments that the potential
for future law changes necessitates a delay in the issuance of these
necessary and appropriate regulations.
---------------------------------------------------------------------------
\3\ See New York State Bar Association Tax Section, Report on
Issues Relating to the Definition of a Creditable tax for Purposes
of Sections 901 and 903 of the Code, Rep't No. 1332 (Nov. 24, 2015).
---------------------------------------------------------------------------
The Treasury Department and the IRS also disagree that the manner
in which U.S. states determine the amount of income that is taxable in
a particular state has any bearing on whether a foreign tax is an
income tax in the U.S. sense. See, for example, Heiner v. Mellon, 304
U.S. 271, 279 (1937) (``It is well settled that in the interpretation
of the words used in a federal revenue act, local law is not
controlling unless the federal statute by express language or necessary
implication, makes its own operation dependent upon state law.'').
Nothing in the Code, legislative history, or case law suggests that
whether a tax is an income tax in the U.S. sense should be determined
by reference to state, as opposed to Federal, income tax principles.
Furthermore, it is immaterial whether a foreign country would provide a
foreign tax credit under its own law for U.S. state income taxes.
In addition, U.S. tax law imposing U.S. tax on income of
nonresidents is not based on notions of destination or customer
location. See sections 864(c), 871, 881, and 882. Moreover, the comment
citing section 250 is inapposite, as that provision merely defines the
scope of sales and services that constitute income from export activity
that qualifies for a special U.S. tax deduction; it does not operate to
assert taxing jurisdiction over income of nonresidents. Similarly,
while proposed Sec. 1.861-18(f)(2)(ii) interprets the place of sale as
being the place of download solely for the purpose of determining the
source of certain types of income from the sale or exchange of digital
property in cases where the statutory source rule looks to the place
where the sale occurs, this rule does not expand the scope of U.S. tax
on income derived by nonresidents. U.S. law does not tax income from
the sale or exchange of property by a nonresident unless the
nonresident conducts a trade or business in the United States (if
applicable, through a U.S. permanent establishment) or disposes of a
United States real property interest as provided under section 897.
One comment stated that the jurisdictional nexus requirement may be
reasonably viewed as consistent with the policy of the foreign tax
credit regime, which, as discussed in part IV.A.2 of this Summary of
Comments and Explanation of Revisions, is not intended to subsidize
foreign jurisdictions at the expense of the U.S. fisc. However, the
comment also asserted that defining what are acceptable standards of
taxing jurisdiction based upon U.S. principles may be unduly
restrictive and may result in non-creditability of foreign taxes even
when the foreign tax law is mostly aligned with U.S. principles. As an
example, the comment posited that if a foreign country's generally-
imposed net income tax on its residents could in certain instances
apply in a manner that is inconsistent with traditional arm's length
principles, that tax would be non-creditable with respect to all
resident taxpayers, even for taxpayers to which income would be
allocated in a manner consistent with arm's length principles.
Comments also pointed out that the jurisdictional nexus requirement
that was included in the 1980 temporary and proposed regulations at
Sec. 4.901-2(a)(1) (flush language) was a more flexible standard
because it required only that the foreign tax follow reasonable rules
regarding source of income, residence, or other bases for tax
jurisdiction, and did not require specific rules that are similar to
Federal income tax rules. In addition, one comment noted that the 1980
temporary regulations also provided that a foreign tax may satisfy the
definition of an income tax even if the foreign tax law differs
substantially from the income tax provisions of the Code. That comment
recommended that the final regulations should provide flexibility to
accommodate the continued evolution of international tax policy
consensus, which may diverge from the U.S. view of traditional taxing
norms.
Comments also asserted that certain U.S. sourcing rules reflect
domestic policies other than jurisdiction to tax. As an example, one
comment noted that the title passage rule for inventory in sections
861(a)(6) and 862(a)(6) reflects administrative simplification
concerns, and former section 863(b) served as an incentive for certain
activities. The comments argued that foreign countries that adopt a
rule different from U.S. source rules due to different choices among
competing policies should not cause the foreign tax to be non-
creditable. One comment argued that diverging views of taxing rights,
especially as between developed and developing countries, have long
existed outside the context of novel extraterritorial taxes. The
comment asserted that diverging views on taxing rights is what makes
relief from double taxation necessary; it is not a reason to deny
creditability of a foreign tax.
The Treasury Department and the IRS generally agree that different
countries may diverge in their approach to asserting jurisdictional
taxing rights, just as countries may have different approaches in
determining the amounts of realized gross receipts and recoverable
costs and expenses included in the foreign taxable base. As a result,
the net gain requirement in existing Sec. 1.901-2, as well as in these
final regulations, does not require strict conformity between foreign
and U.S. tax law. However, the final regulations do require that a
foreign tax must be consistent with the general principles of income
taxation reflected in the Code for it to be an ``income tax in the U.S.
sense.'' These principles include not only those related to determining
realization, gross receipts, and cost recovery, but also principles
related to assertion of taxing rights. The purpose of section 901 is
not to provide double tax relief in all cases in which foreign tax is
imposed on income of a U.S. taxpayer, but rather, to relieve double
taxation only in the case of foreign taxes that are ``income, war
profits, and excess profits taxes''. Accordingly, the purpose of the
regulations under section 901 is to provide clarity and certainty as to
which income tax principles reflected in the Code the foreign tax law
must have for a tax to be an income tax in the U.S. sense within the
meaning of section 901. However, the Treasury Department and the IRS
agree with the comments asserting that certain aspects of the source
requirement can appropriately be revised to be more flexible; these
changes are described in part IV.A.4 of this Summary of Comments and
Explanation of Revisions.
Several comments recommended that the Treasury Department and the
IRS address the policy concerns regarding extraterritorial taxes
through alternative approaches. These comments recommended that the
Treasury Department utilize international forums, such as the Inclusive
Framework and bilateral treaty negotiations, to dissuade foreign
jurisdictions from enacting or imposing these taxes. Comments argued
that the denial of foreign tax credits is unlikely to prevent foreign
jurisdictions from imposing extraterritorial taxes and will instead
harm the U.S. taxpayers operating in those foreign jurisdictions.
[[Page 288]]
One comment asserted that the foreign tax credit regulations should not
be used as a tool to further U.S. foreign policy goals. Another comment
recommended that, instead of adopting the jurisdictional nexus
requirement, the Treasury Department and the IRS consider an
alternative approach for defining what exceeds appropriate taxing
jurisdiction by reference to the criteria that the U.S. Trade
Representative has used to evaluate whether these taxes are
discriminatory and burden U.S. commerce. Finally, one comment asserted
that the jurisdictional nexus requirement would disproportionately
disallow credits for taxes imposed by developing countries, which are
more likely to assert taxing rights in a manner that is inconsistent
with international norms, as compared to taxes imposed by developed
countries.
The Treasury Department and the IRS agree that international forums
can be an effective way of discouraging foreign jurisdictions from
enacting extraterritorial taxes; indeed, the Treasury Department is
actively engaged in and supporting negotiations under the auspices of
the Inclusive Framework that would result in their elimination.\4\
However, contrary to the comments' assertion, the Treasury Department
and the IRS's determination that regulations are necessary and
appropriate to ensure that the U.S. fisc does not bear the costs of
such taxes derives from the text, purpose, and policy of section 901,
and not from any foreign policy goals. The Treasury Department and the
IRS have concluded that these novel extraterritorial taxes (some of
which are currently in force and being levied on U.S. taxpayers) are
contrary to the text and purpose of section 901 and therefore must be
addressed now. Furthermore, nothing in the text, structure, or history
of section 901 suggests that the Treasury Department or the IRS should
consider the level of economic development of a country in determining
whether a foreign tax imposed by that country meets the standards in
section 901. Lastly, the Treasury Department and the IRS have
considered the recommendation to use the criteria used by the U.S.
Trade Representative but have determined that those criteria are
designed for a different purpose (that of evaluating whether the
foreign tax is unreasonable or discriminatory and burdens or restricts
U.S. commerce under U.S. trade laws), and are not suitable for purposes
of defining whether a tax is an income tax in the U.S. sense for
purposes of U.S. tax laws.
---------------------------------------------------------------------------
\4\ See OECD/G20 Base Erosion and Profit Shifting Project,
Statement on a Two-Pillar Solution to Address the Tax Challenges
Arising from the Digitalisation of the Economy (October 8, 2021)
(describing agreement reached by 136 countries to ``remove all
Digital Services Taxes and other relevant similar measures with
respect to all companies, and to commit not to introduce such
measures in the future.'').
---------------------------------------------------------------------------
Finally, one comment recommended that the Treasury Department and
the IRS develop a list of per se creditable and non-creditable taxes to
provide taxpayers certainty and reduce compliance burdens. A per se
list of creditable and non-creditable taxes would require significant
government resources to analyze foreign taxes and maintain such a list,
which would need to be updated every time foreign tax laws change.
Therefore, the final regulations do not adopt this comment.
4. Modifications to the Source-Based Nexus Requirement
Comments argued that the determination of whether foreign sourcing
rules are reasonably similar to U.S. sourcing rules would be complex
and result in significant uncertainty because U.S. sourcing rules are
not sufficiently well-defined. Comments pointed out that the preamble
to the 2020 FTC proposed regulations acknowledged that the U.S. rules
for determining income effectively connected with a U.S. trade or
business have been developed through case law, are not strictly
delineated, and thus were not used as the standard for the activities-
based nexus requirement. The comments suggested that the U.S. sourcing
rules for royalties and services are similarly addressed only in case
law and not well-developed. They contended that it would be difficult
to apply the sparse and inconsistent U.S. case law on royalty sourcing
to determine if a foreign tax law's sourcing rules for royalties are
reasonably similar to U.S. rules. In addition, comments asserted that
the U.S. sourcing rules are designed to distinguish between U.S. and
foreign source income, and are not well-suited for determining, for
example, whether a royalty paid from one CFC to another is specifically
sourced to the payor CFC's jurisdiction of residence. With respect to
services income, one comment noted that it is unclear whether services
should be sourced solely based on the source of the labor or by also
taking into account the location of capital, especially when
significant intangible property is involved. Another comment asked for
clarification on how to evaluate whether a foreign withholding tax that
is imposed both on services performed in the country imposing the tax
and on technical service fees paid by a resident of such foreign
country (regardless of where the services are performed) meets the
source-based nexus requirement; this comment asked whether the
determination of ``reasonably similar'' would depend on how important
technical services are relative to that foreign country's economy.
In response to these comments, the final regulations modify the
source-based nexus requirement to provide additional flexibility and
clarity. Section 1.901-2(b)(5)(i)(B) continues to require that the
foreign sourcing rules must be reasonably similar to the sourcing rules
under the Code. However, in recognition that the Code does not provide
detailed sourcing rules addressing every category of income, or every
type of income within that category, and that the interpretation and
application of the Code sourcing rules are sometimes addressed only in
case law and sub-regulatory guidance, Sec. 1.901-2(b)(5)(i)(B) also
provides that the foreign tax law's application of sourcing rules need
not conform in all respects to the interpretation that applies for
Federal income tax purposes. Thus, for example, the final regulations
require that in the case of gross income arising from gross receipts
from royalties, the foreign tax law must impose tax on such royalties
based on the place of use of, or the right to use, the intangible
property. However, the final regulations do not require that the
foreign law, in determining the place of use of an intangible in a
particular transaction or fact pattern, reach the same conclusion as
the IRS in a particular revenue ruling or a U.S. court in a particular
case.
The final regulations provide additional certainty by specifying
the source principles that foreign tax law must apply to be considered
reasonably similar to U.S. source rules. With respect to income from
services, Sec. 1.901-2(b)(5)(i)(B)(1) provides that gross income
arising from services must be sourced based on where the services are
performed, as determined under reasonable principles, which do not
include determining the place of performance based on the location of
the service recipient. Thus, a withholding tax that is imposed on
payments for services performed in the country imposing the tax would
meet the source-based nexus requirement, but a withholding tax on fees
for technical services performed outside of that country would not meet
the source-based nexus requirement. In addition, the separate levy
rules at Sec. 1.901-2(d)(1)(iii) are modified to provide that
withholding taxes that apply different
[[Page 289]]
sourcing rules to subsets of a single class of gross income of
nonresidents are treated as separate levies. Therefore, a withholding
tax that applies a nonqualifying source rule to a subset of service
income would not be creditable, but because it is treated as a separate
levy the nonqualifying source rule would not prevent a withholding tax
on other services that satisfies the source-based nexus requirement
from qualifying as a creditable tax.
Several comments also pointed out that the United States and the
foreign jurisdiction may disagree on how to characterize the income
from a particular transaction, making it more difficult to determine
whether the foreign tax meets the jurisdictional nexus requirement. The
comments noted that issues of characterization are particularly
prevalent with respect to cross border payments for digital goods. The
comments stated that in respect of software transactions that are
treated as sales of copyrighted articles under Sec. 1.861-18, some
foreign countries regard some or all payments by their resident
taxpayers for software copies as royalties, and accordingly, impose a
royalty withholding tax on those payments. The comments also asserted
that even in cases where a foreign country may not consider the payment
subject to royalty withholding tax, the foreign country may nonetheless
tax other copyrighted article transactions as royalties. As such, the
comments argued, cross border payments for digital goods should be
excepted from the jurisdictional nexus requirement. Another comment
noted that similar characterization questions may arise when
distinguishing between technical service fees and royalties; the
comment queried whether a foreign withholding tax imposed on royalties
that the United States would view as a payment for services would be
determined to be non-creditable or would require an evaluation of the
magnitude of the services relative to the royalty.
Comments also argued that the United States lacks guidance on the
classification and sourcing of income from cloud computing
transactions, noting that the Treasury Department and the IRS have not
yet finalized the proposed cloud computing regulations that were issued
in 2019. The comments asserted that given the evolving U.S. guidance on
the character and source of cloud computing transactions, the
creditability of a foreign tax imposed on such transactions should not
depend on whether foreign law is reasonably similar to U.S. law.
In response to these comments, the final regulations provide that,
in general, foreign tax law applies for purposes of determining the
character of the gross income or gross receipts that arise from a
transaction. See Sec. 1.901-2(b)(5)(i)(B). The determination of
whether the foreign law source rule is reasonably similar to the source
rules under the Code will follow from the foreign law characterization
of that income. If there is no statutory source rule in the Code for a
particular amount that is subject to foreign tax, then the foreign law
source rule will satisfy the source-based nexus requirement if it is
reasonably similar to the U.S. source rule that applies by closest
analogy. However, the final regulations also clarify that in the case
of copyrighted articles, to satisfy the source-based nexus requirement,
the foreign tax law must treat a transaction that is considered the
sale of a copyrighted article under Sec. 1.861-18 (where the acquirer
receives only the right to use a copyrighted article and not, for
example, the right to duplicate and publicly distribute, or the right
to publicly display the article) as a sale of tangible property and not
as a license. See Sec. 1.901-2(b)(5)(i)(B)(3). This rule is consistent
with established U.S. law and international norms. See Sec. 1.861-
18(c); see also OECD Model Tax Convention (2017), commentary to art.
12. The Treasury Department and the IRS have determined that this rule
is necessary to ensure that foreign jurisdictions cannot reclassify
income from sales of copyrighted articles as royalties to assert taxing
rights that are extraterritorial in nature and outside the scope of
what is an income tax in the U.S. sense.
Comments recommended that, if the jurisdictional nexus requirement
is not withdrawn entirely in the final regulations, then payments for
services and payments for digital goods should be excepted from the
source-based nexus requirement. With respect to payment for services,
the comments argued that the U.S. source rule for services is not the
international norm; many countries impose withholding tax on payment
for services made by a resident in the country (or by a nonresident
with a permanent establishment in the country). Comments noted that the
UN Model Tax Convention allows contracting states to impose withholding
taxes on a variety of services fees, and that the United States has
income tax treaties with foreign jurisdictions that allow the foreign
country to withhold tax on payments for services not performed in that
country. Several comments also asserted that withholding taxes on
payments for services are not novel taxes, but rather are long-standing
taxes that are also creditable under existing Sec. 1.903-1.
Specifically, comments pointed to Example 3 of existing Sec. 1.903-
1(b)(3), which concludes that a gross basis tax imposed on a
nonresident for technical services performed outside the country
imposing the tax are creditable. As such, the comments stated, these
withholding taxes are consistent with international norms and the final
regulations should continue to allow these taxes to be creditable.
In addition, comments expressed concern about the increased
incidence of unrelieved double taxation in respect of cross-border
payments for digital services. The comments suggested that under
proposed Sec. 1.861-19, essentially all cloud transactions, as defined
in those proposed regulations, will be classified as services for
Federal income tax purposes. As such, foreign withholding taxes imposed
on payments for those services, if not imposed on the basis that the
services are performed in the country, would be non-creditable under
the proposed source-based nexus requirement. Comments also pointed out
that the effect of the source-based nexus requirement in the 2020 FTC
proposed regulations is to create disparate treatment for software
suppliers based on the approach a supplier adopts to commercializing
the software. As an example, comments pointed out that a software
supplier that makes software available through limited time
subscription is treated under Federal income tax rules as receiving
payments of service fees, whereas a software supplier that provides
software to users through downloads under limited-time licenses is
treated as receiving payments of rents. If a foreign country imposes
withholding taxes on both payments, the withholding tax paid by the
first software supplier would not be creditable (because the U.S.
source rules would not permit the service payment to be sourced based
on the location of the user) whereas the taxes paid by the second
supplier would be creditable (because U.S. source rules would permit
the rental payment to be sourced based on where the user installs the
software copy). The comments argued that there is no policy
justification for such disparate results.
The Treasury Department and the IRS have determined that it is
necessary and appropriate to narrow the circumstances under existing
law (for example, as illustrated in Example 3 of Sec. 1.901-1(b)(3))
in which withholding taxes on payment for services are creditable. The
taxation of services performed by
[[Page 290]]
nonresidents, under U.S. tax law, is clearly limited to cases in which
the services are performed in the United States. Nothing in the Code,
legislative history, or case law indicates that a different approach is
appropriate for technical or digital services. The Treasury Department
and the IRS have determined that the assertion of foreign withholding
taxes on income from services that are not performed within the foreign
jurisdiction is not consistent with an income tax in the U.S. sense and
therefore should not qualify for a credit under section 901.
Furthermore, the Code provides for disparate treatment of classes
of income depending on whether the transaction that gives rise to the
income is characterized as a service, license, sale, or something else.
This different treatment is also reflected in existing international
norms, including the OECD Model Tax Convention. Seeking to conform the
treatment of digital transactions under the Code, or to anticipate
possible future changes to the treatment or classification of digital
transactions, is beyond the scope of these regulations. Instead, the
Treasury Department and the IRS have determined that analyzing whether
a foreign tax is an income tax based on how such income is
characterized under foreign law and comparing the foreign tax law
sourcing rule to U.S. tax principles, provides adequate flexibility to
account for differences between U.S. and foreign law, while adhering to
the requirement that a foreign tax be an income tax in the U.S. sense
to be creditable. Thus, the final regulations do not adopt the
recommendation to except digital services from the jurisdictional nexus
requirement.
One comment noted that the 2020 FTC proposed regulations could
create different results for sales of software, depending on whether
the software is delivered on tangible media or delivered by way of
digital download because there are different U.S. source rules for such
transactions. As an example, the comment explained that a sale of a
software copy that is delivered on tangible media is sourced, under
U.S. income tax principles, based on title passage, whereas the sale of
a copyrighted article delivered through an electronic medium is deemed
to occur, under proposed Sec. 1.861-18(f)(2)(ii), at the location of
download or installation. The comment further noted that if proposed
Sec. 1.861-18(f)(2)(ii) is not finalized, and the title passage rule
continues to apply to digital deliveries, then for U.S. income tax
purposes, the source of the income would be determined based upon where
the servers from which the software copy is made available is located.
The comment argued that these distinctions should not be the basis for
causing the supplier of the software to be eligible or ineligible for a
foreign tax credit.
The Treasury Department and the IRS have determined that it is
unnecessary to require a foreign tax law's sourcing rule for income
derived from the sale or other disposition of property to conform with
U.S. source rules. This is because under the Code, the United States
imposes tax on such income of a nonresident only if the nonresident
conducts a U.S. trade or business (if applicable, through a U.S.
permanent establishment) or the income is derived from real or movable
property situated in the United States. Thus, the final regulations
provide that, with respect to foreign tax imposed on income derived
from the sale or other disposition of property, including copyrighted
articles sold through an electronic medium, the tax meets the
attribution requirement only if the inclusion of the income in the
foreign tax base meets the activities-based nexus requirement in Sec.
1.901-2(b)(5)(i)(A) or the property-based nexus requirement in 1.901-
2(b)(5)(i)(C).
5. Activities-Based Nexus Requirement
One comment stated that the physical presence and permanent
establishment standard is not an inherent part of the U.S. tax system;
rather, it is a political invention in the 1920s that was the result of
bargaining between the United States and its treaty partners. The
comment stated that by adopting this standard in the 2020 FTC proposed
regulations, the Treasury Department and the IRS ignored the economic
realities of digital economies and lacked reasoned decision-making. The
comment recommended that the final regulations provide that the
jurisdictional nexus requirement is satisfied when consumers of a
service rendered by a foreign corporation are located in the taxing
jurisdiction.
The Treasury Department and the IRS disagree with the comment's
assertion that the physical presence and permanent establishment
standard is not an appropriate measure for nexus. The permanent
establishment standard is a critical part of the U.S. Model Income Tax
Convention, existing U.S. bilateral tax treaties, and the OECD Model
Tax Convention. Furthermore, a physical presence standard is consistent
with the nexus rules in section 864, which provide that only income
effectively connected with a trade or business that a foreign resident
conducts in the United States is subject to U.S. tax. Contrary to the
comment's contention, the 2020 FTC proposed regulations did not ignore
the economic realities of digital economies; rather, they adopted a
standard based on the existing Code and traditional international
taxing norms. The Treasury Department and the IRS have determined that
the income tax principles in the Code do not allow for the assertion of
taxing rights based solely on the existence of consumers in a
jurisdiction.
One comment asserted that, where the foreign law includes elements
in common with the effectively connected income standard under section
864(c), a broader standard for attributing income to nonresidents on
the basis of the nonresidents' activities as well as activities of the
nonresident's related parties should satisfy the activities-based nexus
requirement of the 2020 FTC proposed regulations. The Treasury
Department and the IRS disagree with this comment. Taking into account
activities of the nonresident's related parties would be inconsistent
with the principles reflected in the U.S. Model Income Tax Convention,
and the OECD Model Tax Convention, as well as in section 864 (unless
the other party is acting on behalf of the nonresident). Accordingly,
the final regulations at Sec. 1.901-2(b)(5)(i)(A) clarify that the
activities-based attribution requirement is not met when the
nonresident is deemed to have a trade or business in the taxing
jurisdiction by reason of activities conducted by another person, or
when the foreign tax law attributes profits to the nonresident based
upon the activities of another person, other than in the case of a
party acting on behalf of the nonresident or in the case of a pass-
through entity of which the nonresident is an owner. In addition, the
final regulations clarify in Sec. 1.901-2(b)(5)(i)(A) that foreign tax
law that attributes income to a nonresident by taking into account as a
significant factor the mere location of persons from which a
nonresident makes purchases does not meet the activities-based nexus
requirement.
Comments requested that taxes paid to Puerto Rico be exempted from
the application of the jurisdictional nexus requirement because, as a
U.S. territory, its taxes should not be treated in the same manner as
taxes imposed by a foreign country. For Federal income tax purposes, a
credit is allowed for income taxes paid or accrued to any foreign
country or United States territory. See section 901(b)(1); see also
section 903. As no distinction is made between taxes imposed by foreign
countries and those imposed by U.S. territories, the final regulations
follow the 2020 FTC
[[Page 291]]
proposed regulations in applying the same standards in defining what is
a creditable income tax regardless of whether the tax is imposed by a
foreign country or a U.S. territory. However, as described in more
detail in part IV.F.2 of this Summary of Comments and Explanation of
Revisions, a special transition rule applies to defer for one year the
applicability date of the final regulations under section 903 with
respect to certain taxes paid to Puerto Rico.
Another comment recommended that the example in proposed Sec.
1.901-2(c)(3) (Sec. 1.901-2(b)(5)(iii) of the final regulations) be
expanded to illustrate the application of the attribution requirement
in the case where a nonresident taxpayer is earning income from
electronically supplied services in a country that imposes tax on such
services (ESS tax) and the taxpayer either (1) maintains its own branch
in the foreign country imposing the tax, with employees of the branch
conducting routine sales, marketing, and customer support functions or
(2) uses a related party disregarded entity resident in that country to
perform local marketing, customer support, and other routine functions.
With respect to the second scenario, the comment noted that where the
ESS tax is imposed on the resident disregarded entity, if the entity's
tax base is determined under arm's length principles, without taking
into account as a significant factor the location of customers, users,
or any other similar destination-based criterion, then the ESS tax
would meet the residence-based nexus requirement and would be
creditable. The comment suggested that in the first scenario, although
the ESS tax is not imposed on the basis of a nonresident's activities
located in the country, the portion of the ESS tax that corresponds to
the portion of a separate nonresident corporate income tax imposed on
the branch's effectively-connected income that would meet the
activities-based requirement (based on the actual activities performed
by the branch) should be considered to meet the activities-based nexus
requirement if the country does not impose the tax on the branch's
effectively-connected income.
The Treasury Department and the IRS agree with the comment's
analysis and conclusion in the second scenario but disagree with the
analysis and conclusion in the first scenario. Whether a foreign tax
meets the requirements of Sec. 1.901-2(b), including the attribution
requirement, is determined based solely on the terms of the foreign tax
law, and not on a taxpayer's specific facts. Thus, the fact that a
separate levy that the foreign country could have imposed on
nonresident taxpayers with respect to their branch operations in the
foreign country could meet the attribution requirement in a particular
factual circumstance does not mean that a different tax that is an ESS
tax, or any portion of an ESS tax, would be deemed to meet the
attribution requirement.
6. Property-Based Nexus Requirement
One comment requested clarification on whether a foreign tax law
similar to the U.S. Foreign Investment in Real Property Tax Act
(FIRPTA) regime under section 897 would satisfy the proposed property-
based nexus requirement. It noted that under the 2020 FTC proposed
regulations, a foreign tax law identical to FIRPTA may not meet the
proposed property-based nexus rule if (consistent with section 897) it
included in the tax base a portion of the gain from the sale of shares
in a foreign real property holding corporation (within the meaning of
section 897(c)(2)) that does not correspond to foreign real property
interests. The comment further noted that a foreign levy imposed on a
nonresident's gain from the sale of shares of a corporation
attributable to real property in the taxing jurisdiction would be
creditable under the proposed property-based nexus rule, even if
(inconsistent with section 897) the corporation is not a resident of
the taxing jurisdiction.
In response to this comment, the final regulations at Sec. 1.901-
2(b)(5)(i)(C) clarify that a foreign tax may include in its base gross
receipts that are attributable to the sale or disposition of real
property situated in the foreign country, or to the disposition of an
interest in a corporation or other entity that is a resident of the
foreign country that owns real property situated in the foreign
country, under rules reasonably similar to those in section 897. In
addition, a foreign tax imposed on the basis of the situs of property
may include in its base gains derived from the sale or other
disposition of property forming part of the business property of a
taxable presence in the foreign country as well as gains from the
disposition of an interest in a partnership or other passthrough entity
that has a taxable presence in the foreign country to the extent the
gains are attributable to the entity's business property in that
foreign country, under rules that are reasonably similar to those in
section 864(c). A foreign tax on any other gains of a nonresident will
not satisfy the property-based attribution requirement.
7. Interaction With Income Tax Treaties
The preamble to the 2020 FTC proposed regulations confirmed that
the proposed regulations in Sec. Sec. 1.901-2 and 1.903-1, when
finalized, would not affect the application of existing income tax
treaties to which the United States is a party with respect to covered
taxes (including any specifically identified taxes) that are creditable
under the treaty.
One comment recommended that the final regulations expressly
provide that the regulations will not affect the creditability of
foreign taxes covered by an existing income tax treaty. The comment
also argued, however, that relying on the U.S. treaty network as the
sole mechanism for relieving double tax for companies operating in
foreign countries with source or other jurisdictional taxing norms that
differ from U.S. taxing norms is not equitable. It noted that the
United States only has income tax treaties with 68 countries, and that
the United States has few treaties with countries in South America and
Africa. The comment stated that the treaty negotiation process is
laborious and that the Treasury Department considers the level of trade
and investment between the countries in determining with which
countries it engages in treaty negotiations, with the result being that
the United States has historically declined to negotiate treaties with
countries that have smaller economies, including developing countries.
Another comment requested that the Treasury Department and the IRS
specifically address the interaction of the jurisdictional nexus
requirement with U.S. income tax treaties that have allowed the treaty
partner to impose a capital gains tax on a nonresident taxpayer on the
sale of stock of a corporation resident in the treaty country
regardless of whether the shares constitute a real property interest or
are attributable to a permanent establishment in the treaty country.
The comment noted that, despite the statement in the preamble to the
2020 FTC proposed regulations, it is unclear how the double taxation
articles of U.S. income tax treaties, which often provide that the
United States agrees to allow a foreign tax credit subject to the
limitations of U.S. law, would be interpreted in light of these
regulations. The comment recommended that the Treasury Department and
the IRS modify the jurisdictional nexus requirement such that foreign
taxes imposed on gains from the disposition of stock of a corporation
sourced on the
[[Page 292]]
basis of residence of the corporation continue to be creditable.
Comments also asked for clarification regarding the effect the
final regulations would have on a foreign tax that is a covered tax
under an existing U.S. income tax treaty if the foreign tax is paid by
a CFC, which is not eligible for the benefits given to U.S. residents
under the treaty. One comment noted that because CFCs are not U.S.
residents, taxes paid by the CFC on a foreign-to-foreign payment would
not be creditable under the U.S. income tax treaty with the source
country. The comment questioned whether this means that a foreign tax
would not be creditable when paid or accrued by a CFC even though it
would be creditable if paid or accrued directly by a U.S. taxpayer.\5\
The comment pointed out that in this case, the United States has
already acknowledged the legitimacy of the treaty partner's claim to
taxing rights, even if it conflicts with U.S. principles; thus, the tax
should be creditable even if paid by a CFC. Another comment similarly
noted that, in respect of foreign taxes imposed on gains from the
disposition of stock of a resident corporation that are creditable
under certain U.S. treaties, such treaties would ensure creditability
of those taxes only when paid by U.S. persons, and not, for example,
when paid by an upper-tier CFC upon the disposition of lower-tier CFC
stock.
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\5\ Another comment made a similar point in connection with
recommending that all proposed revisions to the net gain requirement
be withdrawn. That comment noted that taxpayers that are operating
in a country with which the United States has an income tax treaty
may not be insulated from uncertainty regarding the creditability of
foreign taxes because the treaties are unclear as to the
creditability of foreign taxes listed in the treaty that are
incurred by foreign subsidiaries and deemed paid by U.S. taxpayers
under section 960. That comment is addressed in this part IV.A.7. of
the Summary of Comments and Explanation of Revisions.
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In response to these comments, the final regulations clarify in
Sec. 1.901-2(a)(1)(iii) that a foreign tax that is treated as an
income tax under the relief from double taxation article of an income
tax treaty that the United States has entered into with the country
imposing the tax meets the definition of a foreign income tax as to
U.S. citizens and residents of the United States that elect to claim
benefits under that treaty. However, as the comments noted, CFCs are
not treated as U.S. residents under U.S. income tax treaties, so CFCs
resident in a third country do not qualify for benefits under U.S.
income tax treaties. Because U.S. income tax treaties do not limit the
application of the treaty partner's taxes imposed on third-country
CFCs, the final regulations clarify that taxes paid to a U.S. treaty
partner by a third-country CFC are treated as a separate levy that must
independently satisfy the requirements of section 901 or 903 to be
creditable.
However, the final regulations clarify that any limitations that a
foreign country has agreed to under its treaties with other
jurisdictions that apply to nonresident CFCs would be taken into
account in determining whether such levy meets the requirements of
Sec. 1.901-2(b) or Sec. 1.903-1(b) when paid by the CFC. See Sec.
1.901-2(a)(1)(iii). Thus, for example, in determining whether a foreign
country's nonresident corporate income tax meets the activities-based
jurisdictional requirement of Sec. 1.901-2(b)(5)(i)(A), when the tax
is paid by a CFC that is resident in a third country, any limitations
or modifications that the first foreign country has agreed to under the
permanent establishment and business profits articles of an income tax
treaty with the third country are taken into account. The final
regulations make corresponding modifications to the separate levy rules
to provide that a foreign levy that is modified by a particular treaty
is treated as a separate levy. See Sec. 1.901-2(d)(1)(iv).
B. Net Gain Requirement
1. In General
The 2020 FTC proposed regulations modified the net gain requirement
to limit the role of the predominant character analysis in determining
whether a tax meets each of the components of the net gain
requirement--the realization requirement, the gross receipts
requirement, and the net income requirement (which under the 2020 FTC
proposed regulations is referred to as the cost recovery requirement).
The 2020 FTC proposed regulations also limited the prevalence of the
empirical analysis required by the existing regulations, which asks
whether a foreign tax is likely to reach net gain in the ``normal
circumstances'' in which it applies. Instead, the 2020 FTC proposed
regulations generally provided that the determination of whether a tax
satisfies each of the realization, gross receipts, and cost recovery
requirements under the net gain requirement is based on the terms of
the foreign tax law governing the computation of the tax base. See
proposed Sec. 1.901-2(a)(3). The preamble to the 2020 FTC proposed
regulations explained that reduced reliance on empirical analysis would
allow taxpayers and the IRS to evaluate the nature of the foreign tax
based on objective and readily available information and would lead to
more consistent and predictable outcomes.
Several comments recommended that instead of finalizing the
proposed modifications to the net gain requirement, the Treasury
Department and the IRS should either retain the predominant character
test of the existing regulations or propose less extensive changes to
the net gain requirement and provide transition rules. Some of these
comments stated that the proposed rules would create too rigid a
standard that would lead to increased instances of double taxation,
putting U.S. companies at a competitive disadvantage. One comment
stated that under the proposed standard, a credit may not be allowed
for a foreign tax that is an income tax in the U.S. sense based on the
actual operation of the foreign tax. Another comment asserted that the
proposed standard would place U.S. multinationals operating in
developing countries at a significant competitive disadvantage compared
with foreign competitors operating in the same developing countries
that do not face the same risk of double taxation because they are
subject to a participation exemption or a less restrictive foreign tax
credit regime.
Comments stated that the predominant character and facts and
circumstances analysis of the existing regulations is a better approach
because there is a lack of uniformity in the income tax systems across
different jurisdictions and because a particular country's tax system
can regularly change over time. Comments stated that the existing
regulations provide the necessary flexibility to allow a credit to be
claimed for foreign taxes that are calculated with variations from U.S.
tax principles. In addition, several comments questioned whether
administrative difficulties with applying the predominant character
test of the existing regulations was a legitimate or sufficient
justification for removing the test, noting that the controversies over
creditability of foreign taxes have not been pervasive or unresolved
enough to justify the new more objective standard.\6\ Several comments
stated that instead of reducing administrative burdens the proposed
changes add complexity and reduce certainty
[[Page 293]]
because they require taxpayers to compare foreign and U.S. tax law,
including statutes, regulations, case law, rulings, and pronouncements,
with any subsequent changes to either foreign or U.S. law requiring re-
evaluation of whether there is sufficient conformity.
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\6\ One comment made this assertion specifically with respect to
the removal of the alternative gross receipts test of the existing
regulation, noting that there have been only three court cases
involving the gross receipts test over the past four decades. That
comment is addressed in this part IV.B.1 of the Summary of Comments
and Explanation of Revisions; other comments regarding the gross
receipts requirement are discussed in part IV.B.2 of the Summary of
Comments and Explanation of Revisions.
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Comments also asserted that it is not realistic for the Treasury
Department and the IRS to expect foreign tax law to conform
substantially to U.S. tax law. These comments noted that different
jurisdictions use different means to protect their tax base and that
some countries may have a relatively simple tax regime and choose to
protect their base through disallowance of deductions. Comments
suggested that a foreign tax should not have to strictly conform to
U.S. rules; it should be creditable if it has the essential elements of
an income tax in the U.S. sense. Comments also asserted that the Code
definition of gross income and allowable deductions reflect evolving
priorities of Congress and should not serve as the determinative
standard of a model income tax that other countries should follow.
Finally, another comment stated that the significant changes made by
the 2020 FTC proposed regulations would fundamentally change existing
U.S. tax laws and policies to a degree that only Congress can implement
through legislation.
As explained in part IV.A.2 of this Summary of Comments and
Explanation of Revisions, Congress did not prescribe a fixed definition
of the term ``income tax'' for purposes of section 901 or 903. As a
result, the meaning of the term has been developed and refined through
administrative guidance and case law since 1919. This body of law has
followed the guiding principle that the determination of whether a
foreign tax is an income tax for purposes of sections 901 and 903 is
made by reference to U.S. tax law. The 1983 final regulations followed
this principle and, influenced by court opinions decided in the years
preceding those regulations, adopted an approach that required a
foreign tax to be examined in the normal circumstances in which the tax
is applied to determine whether the predominant character of the tax is
that of an income tax in the U.S. sense. As explained in the preamble
to the 2020 FTC proposed regulations, the IRS's experience over the
past 40 years has highlighted the significant administrative
difficulties with applying the predominant character test, the
ambiguities inherent in the empirical analysis required to apply the
test, and the inconsistent outcomes that may result from applying the
predominant character test. See 85 FR 72089-72092. In addition, the
courts that applied the 1983 regulations further brought into focus the
type of quantitative empirical evidence, such as private financial data
on the extent of disallowed expenses, that the IRS and the taxpayer may
need to obtain and analyze to determine whether a foreign tax is an
income tax under the empirical tests of the existing regulations. See,
for example, Texasgulf Inc. v. Comm'r, 172 F.3d 209, 216 (2d Cir. 1999)
(court examined statistics for claimed processing allowances and for
nonrecoverable expenses across a 13-year period derived from a study
conducted by taxpayer's expert to determine if alternative allowance
provided under the Ontario Mining Tax effectively compensated for
nonrecovery of significant expenses); Exxon Corp. v. Comm'r, 113 T.C.
338 (1999) (both parties relied heavily on expert witnesses from the
petroleum industry, the U.K. government, and from legal, tax,
accounting, and economic professions).
The comments that recommended against the approach in the 2020 FTC
proposed regulations did not suggest any alternative approaches that
would not require the empirical analysis necessitated by the existing
regulations. Due to the difficulty that taxpayers and the IRS face in
properly applying the existing regulations, the Treasury Department and
the IRS have determined that it is necessary and appropriate to
finalize the rule in the 2020 FTC proposed regulations that the
determination of whether a foreign tax meets the net gain requirement
is primarily based on the terms of the foreign tax law governing the
computation of the tax base. This approach allows taxpayers and the IRS
to evaluate the nature of the foreign tax based on more objective and
readily available information.
The Treasury Department and the IRS disagree with the comments that
suggested that the existing regulations entail minimal administrative
burdens or that the rules in the 2020 FTC proposed regulations will
increase administrative burdens. Although the final regulations require
a comparison of foreign law to U.S. law, that comparison is generally
done by examining the terms of the foreign tax law, which taxpayers
must do in any case in order to compute their foreign tax liability,
rather than by examining difficult-to-obtain foreign tax return and
private financial data to determine the effect of the tax (as is
required under the existing regulations).
In addition, the Treasury Department and the IRS disagree that the
final regulations will add complexity or create more disputes. The fact
that relatively few court cases have addressed the definition of an
income tax under Sec. 1.901-2 does not suggest that the existing
regulations are clear and easy to apply, but rather that they are
challenging for the IRS to administer. It is unclear whether taxpayers
are correctly applying the existing requirements in Sec. 1.901-2 by
performing the empirical analysis required by the regulations. Because
the existing regulations are difficult for taxpayers to apply and for
the IRS to administer, there is potential for the requirements in
existing Sec. 1.901-2 to be applied incorrectly, a result that is
detrimental to sound tax administration.
The Treasury Department and the IRS have determined that the
changes made in the final regulations will increase certainty and will
prevent the need for the IRS to gather and evaluate data that are not
readily available in order to ensure that taxpayers are appropriately
applying the relevant empirical analysis--particularly in the case of
novel extraterritorial taxes that are generally imposed on a gross
basis (such as digital services taxes) and that would meet the
requirements of the existing regulations only if the nonrecoverable
costs and expenses attributable to that gross income, together with the
tax paid by all persons subject to the tax, can empirically be proven
almost never to result in a loss. The Treasury Department and the IRS
disagree with comments that suggest that administrative concerns are
not a sufficient reason for revising the regulations. Having clear,
administrable rules that can be consistently applied is critical to
sound tax administration.
The Treasury Department and the IRS also disagree with the comments
suggesting that the 2020 FTC proposed regulations reflect a fundamental
change to existing foreign tax credit policies or that the existing
regulations do not require taxpayers to compare foreign and U.S. tax
law (including statutes, regulations, case law, rulings, and
pronouncements) to determine whether a tax is creditable. In fact, for
a foreign taxable base that deviates from the U.S. computational norm
of realized gross receipts reduced by significant costs and expenses,
the predominant character test by its terms requires taxpayers to
perform an empirical analysis every year to determine whether a tax is
creditable, such that changes in the empirical impact of a foreign tax
(despite no change in the terms of the tax) could impact the
creditability analysis. The final regulations will simplify the
determination of whether a
[[Page 294]]
foreign levy is an income tax in the U.S. sense by eliminating this
burdensome inquiry.
Furthermore, the Treasury Department and the IRS disagree that the
final regulations will result in additional double taxation in a manner
that is inconsistent with the statute, or that they inappropriately
place U.S. multinationals at a competitive disadvantage compared to
foreign competitors from a country with a participation exemption
regime or a less-restrictive foreign tax credit system. Section 901
allows credits only for foreign taxes that are income taxes in the U.S.
sense, and this standard is met only if there is substantial conformity
in the principles used to calculate the foreign tax base and the U.S.
tax base. Absent such conformity, no credit is appropriate under
section 901. Finally, the manner in which foreign countries relieve
double taxation for its resident taxpayers does not have any bearing on
the appropriate interpretation of section 901, which provides a credit
only for foreign income taxes, not all foreign taxes.
In addition, some comments stated that the proposed rules, which
focus on the terms of the foreign law in determining whether the net
gain requirement is met, inappropriately shift the analysis from the
substance to the form of a foreign levy. In particular, some comments
asserted that this is inconsistent with court cases, including PPL
Corp. v. Comm'r, 569 U.S. 329 (2013), in which courts have stated that
the substantive effects of a tax should be considered when determining
whether a tax constitutes a foreign income tax. Other comments stated
that the predominant character analysis of the existing regulations
better reflects the guidance from cases such as Biddle and Keasbey &
Mattison Co. v. Rothensies, 133 F.2d 894 (3rd Cir. 1943), which confirm
that whether a foreign tax is creditable should be determined on the
basis of its substantive resemblance to an income tax in the U.S.
sense.
The Treasury Department and the IRS disagree with comments
suggesting that the approach adopted in the 2020 FTC proposed
regulations to minimize the role of empirical analysis is inconsistent
with the principles applied by the courts in PPL, Biddle, or Keasbey to
determine whether a foreign tax is an income tax in the U.S. sense. The
Supreme Court in Biddle established that statutory terms such as
``income tax'' are properly interpreted to have the meaning understood
under U.S. tax law; the Keasbey court, citing Biddle, stated that ``a
tax paid [to] a foreign country is not an income tax within the meaning
of [section 901] unless it conf[o]rms in its substantive elements to
the criteria established under our revenue laws.'' Keasbey, 133 F.2d at
897. The Supreme Court in PPL determined the creditability of the U.K.
windfall tax by applying the predominant character test of the existing
regulations, which evaluates the substantive effect of the tax by
resort to empirical analysis of the effect of alternative methods of
determining gross receipts and deductible expenses. Citing Biddle, the
Supreme Court stated that ``instead of the foreign government's
characterization of the tax, the crucial inquiry is the tax's economic
effect. In other words, foreign tax creditability depends on whether
the tax, if enacted in the U.S., would be an income, war profits, or
excess profits tax.'' PPL, 569 U.S. at 335.
Consistent with the guiding principle that a creditable tax must be
an income tax in the U.S. sense, the 2020 FTC proposed regulations
required a comparison of the foreign tax law to the U.S. tax law to
determine whether the provisions for computing the base on which the
foreign tax is imposed conforms with U.S. criteria for an income tax
(that is, a tax imposed on realized gross receipts reduced by allocable
costs and expenses). Under the 2020 FTC proposed regulations, the
foreign government's characterization of the tax or the name given to
the tax do not control the determination of creditability; rather, the
determination involves an examination of the substantive provisions of
the foreign tax law that govern the computation of the income that is
subject to tax. The Supreme Court in PPL was applying the predominant
character test in the existing regulations and was not interpreting the
statute. Because the final regulations modify the standard for
determining whether a foreign levy is an income tax in the U.S. sense,
the final regulations do not conflict with the PPL decision. Thus, the
Treasury Department and the IRS disagree with the comments' contentions
that the 2020 FTC proposed regulations have inappropriately shifted the
inquiry away from the substance, or the substantive economic effect, of
the foreign tax.
2. Alternative Gross Receipts Test
The 2020 FTC proposed regulations removed the ``alternative gross
receipts test'' in existing Sec. 1.901-2(b)(3), which provided that a
foreign tax meets the gross receipts requirement if it is computed
under a method that is likely to produce an amount that is not greater
than the fair market value of actual arm's length gross receipts. Under
proposed Sec. 1.901-2(b)(3)(i), a foreign tax meets the gross receipts
tests only if the tax is imposed on actual gross receipts, or is
imposed on deemed gross receipts arising from pre-realization timing
difference events (for example, a mark-to-market regime, tax on the
physical transfer, processing, or export of readily marketable
property, or a deemed distribution or inclusion), or is imposed on the
basis of gross receipts from an insignificant non-realization event. In
addition, proposed Sec. 1.901-2(b)(3)(i) provided that, for purposes
of the gross receipts test, amounts that are properly allocated to a
taxpayer under the jurisdictional nexus rules in proposed Sec. 1.901-
2(c), such as pursuant to transfer pricing rules that properly allocate
income to a taxpayer on the basis of costs incurred by that entity, are
treated as the taxpayer's actual gross receipts.
Several comments criticized the removal of the alternative gross
receipts test and asked that it be retained. Comments stated that
eliminating the alternative gross receipts test creates an overly
restrictive gross receipts requirement that can cause foreign taxes to
not qualify as income taxes due to small or formalistic differences in
how foreign law measures gross receipts as compared to U.S. law. One
comment noted that it is not unusual for taxing jurisdictions to
provide alternate measures of gross receipts to avoid compliance
difficulties. The comment also noted that U.S. tax law uses alternative
gross receipts, such as using the applicable Federal rate (determined
by the IRS) to determine interest deemed to be received by certain
lenders. Other comments noted that the U.S. standards for measuring
gross receipts and gross income have changed over time, and there is no
static view of gross receipts against which to measure foreign law. One
such comment pointed to realized cash receipts, the accrual method,
financial statement income, and in limited instances mark-to-market as
examples of varying ways to compute gross receipts. Another comment
pointed to the changes to the rules for determining the taxable year
for income inclusions under section 451 from 2012 to 2018.
One comment asserted that the proposed regulation's treatment of
alternative measures of gross receipts determined by applying a markup
to costs (which does not meet the gross receipts requirement) is
irreconcilable with the rule in proposed Sec. 1.901-2(b)(3)(i) that
treated allocations of gross income under transfer pricing methods to a
taxpayer as actual gross receipts. The comment contended that there is
no
[[Page 295]]
logical reason for treating a foreign law that allows taxpayers to use
a cost-plus transfer pricing methodology as meeting the gross receipts
test, but not a foreign law that uses a measurement of gross receipts
based on costs, and that the 2020 FTC proposed regulations will result
in significant controversy in distinguishing the two situations. The
comment recommended that the Treasury Department and the IRS continue
to treat foreign income taxes based on alternative measurements of
gross receipts as meeting the gross receipts test, so long as the
taxpayer can show that the alternative is likely to produce an amount
not greater than fair market value.
One comment requested clarification on how the proposed rules would
apply in situations where the foreign jurisdiction imposes a levy on a
combination of actual gross receipts and receipts computed based on
some other method.
In addition, comments pointed out that the Treasury Department and
the IRS previously proposed to eliminate the alternative gross receipts
test in the 1980 proposed and temporary regulations under sections 901
and 903, but after extensive consideration decided to retain it in the
1983 final regulations. The comments asked the Treasury Department and
the IRS to justify the reconsideration of the elimination of the
alternative gross receipts test, given that such elimination was
previously rejected.
The Treasury Department and the IRS have determined that it is
necessary and appropriate to remove the alternative gross receipts test
because, in general, a tax that is imposed on an amount greater than
actual realized gross receipts, or greater than the value of property,
is not an income tax in the U.S. sense. In addition, the decision to
provide an alternative gross receipts test in the 1983 final
regulations, even if made in response to comments, does not preclude
the Treasury Department and the IRS from later re-evaluating and
removing the rule. The IRS' experience with applying the alternative
gross receipts test has shown that the test is vague and unduly
burdensome to administer because of the empirical evaluation needed to
determine whether the alternative method is likely to produce an amount
that is not greater than fair market value.
However, in response to comments received, the final regulations
provide that deemed gross receipts resulting from deemed realization
events or insignificant non-realization events that meet the
realization requirement in Sec. 1.901-2(b)(2) will meet the gross
receipts requirement if the deemed gross receipts are reasonably
calculated to produce an amount that is not greater than fair market
value. For example, deemed gross receipts resulting from a mark-to-
market regime or foreign tax law that imputes interest income under a
provision similar to section 7872 would satisfy the gross receipts
requirement.
The Treasury Department and the IRS disagree with the comment that
seems to conflate a situation when actual gross receipts arise from a
transaction between related parties that is priced under a cost-plus
transfer pricing methodology with the transactions contemplated in the
2020 FTC proposed regulations. Such a related-party transaction is
distinct from a foreign levy that imposes tax on deemed gross receipts
that are determined based upon a markup of costs rather than the actual
gross receipts from the transaction among unrelated parties. The former
involves using a transfer pricing methodology to determine the
appropriate payment (that is, the actual gross receipts as reported or
adjusted for tax purposes) that a taxpayer in a transaction with a
related party should receive based upon arm's length principles. In
contrast, in the context of transactions between unrelated parties,
using a measure of deemed gross receipts based on costs may have no
relationship to the actual gross receipts.
However, the Treasury Department and the IRS have determined that
the reference in proposed Sec. 1.901-2(b)(3)(i) to gross receipts that
are properly allocated to a taxpayer under a foreign tax meeting the
jurisdictional nexus requirement was potentially confusing and
unnecessary, because such a related party transfer pricing methodology
would result in actual gross receipts, either by means of an actual
payment or a constructive payment resulting from a receivable recorded
on the taxpayer's books and records. Accordingly, the reference to
gross receipts determined under a transfer pricing methodology is
removed from the final regulations, and an example is added to the
final regulations at Sec. 1.901-2(b)(3)(ii)(B) to illustrate the
intended application of the rule.
3. Cost Recovery Requirement
The 2020 FTC proposed regulations modified various aspects of the
net income test of the existing regulations (referred to as the ``cost
recovery requirement'' under the 2020 FTC proposed regulations) to
ensure that a foreign tax is a creditable tax only if the determination
of the foreign tax base conforms in essential respects to the
determination of taxable income under the Code.
Several comments recommended against adopting the proposed changes
to the cost recovery requirement out of concern that the proposed
changes will result in more instances of unrelieved double taxation.
One comment asserted that the effect of the revisions to the cost
recovery requirement would be to limit creditability of foreign levies
that have been traditionally characterized as income taxes based solely
on minor deviations between U.S. tax principles and the foreign law.
The comment asserted that the revised standard is stricter than the
standard traditionally applied by the courts, and unreasonably narrows
the standard since the term ``foreign income, war profits, and excess
profits taxes'' in the statute has not been changed.
In general, the Treasury Department and the IRS disagree with
comments that the revised cost recovery standard will result in
additional unrelieved double taxation in a manner that is inconsistent
with the policies underlying section 901. This is because double
taxation that merits relief under section 901 occurs only if there is
substantial conformity in the principles used to calculate the foreign
tax base and the U.S. tax base. However, the final regulations modify
certain aspects of the cost recovery requirement in order to provide
additional flexibility and to reduce instances where minor deviations
between U.S. principles and foreign tax law could cause a foreign levy
to be non-creditable; these changes are described in part IV.B.3.ii and
iii of this Summary of Comments and Explanation of Revisions.
i. Gross Basis Taxes
The 2020 FTC proposed regulations removed the nonconfiscatory gross
basis tax rule of the existing regulations. That rule provided that a
foreign levy whose base is gross receipts is treated as meeting the
cost recovery requirement if the foreign levy is almost certain to
reach net gain in the normal circumstances in which it applies because
costs and expenses will almost never be so high as to offset gross
receipts or gross income, and the rate of the tax is such that after
the tax is paid persons subject to the tax are almost certain to have
net gain. Instead, proposed Sec. 1.901-2(b)(4)(i)(A) provided that a
foreign levy must permit recovery of the significant costs and expenses
attributable to such gross receipts, or permit recovery of an
alternative amount that by its terms may be greater, but will never be
less, than the actual amounts of such significant costs and
[[Page 296]]
expenses. Proposed Sec. 1.901-2(b)(4)(i)(A) further provided that a
foreign tax that is imposed on gross receipts or gross income and that
does not permit recovery of any costs or expenses does not meet the
cost recovery requirement, even if in practice there are no or few
costs and expenses attributable to all or particular types of gross
receipts included in the foreign tax base.
One comment stated that the removal of the nonconfiscatory gross
basis tax rule is inconsistent with court decisions that predate the
1983 regulations and that have concluded that a tax on gross receipts
may qualify as a creditable income tax so long as it reaches net
income. The comment specifically cited Seatrain Lines, Inc. v. Comm'r,
46 B.T.A. 1076 (1942), Santa Eulalia Mining Co. v. Comm'r, 2 T.C. 24
(1943), and Bank of America Nat. Trust & Sav. Ass'n v. U. S., 459 F.2d
513 (Ct. Cl. 1972). The comment stated that in determining whether a
foreign levy is an income tax, the courts focus on the nature of the
income that is the subject of the tax and whether that type of income
is likely to involve significant expenses that could result in a net
loss being realized from the activity being taxed. The comment further
contended that digital services taxes would qualify as creditable
income taxes under this analysis, because the amounts of costs and
expenses associated with the type of gross receipts subject to the
digital services taxes are never so high as to cause businesses subject
to the tax to incur a loss after payment of the tax. No explanation or
evidence (whether empirical or anecdotal) was provided to support this
assertion.
The comment further asserted that the explanation for the proposed
change in the preamble to the 2020 FTC proposed regulations is
unpersuasive. It contended that the court decisions involving the net
gain requirement have not reflected any administrative difficulties. As
such, the comment stated that the removal of the nonconfiscatory gross
basis tax rule in the 2020 FTC proposed regulations is unjustified and
recommended that the existing rule be retained.
The Treasury Department and the IRS have determined that foreign
taxes that do not permit recovery of significant costs and expenses are
not income taxes in the U.S. sense. Although some cases preceding the
1983 regulations, such as those cited in the comment, determined that a
gross basis tax could be an income tax in the U.S. sense, other cases
reached a different conclusion. See C.I.R. v. American Metal Co., 221
F.2d 134 (1955) (a Mexican Production Tax was not creditable because it
applied regardless of whether miners made a profit or sales); Keasbey,
133 F.2d 894 (tax imposed under the Quebec Mining Act was not an income
tax in the U.S. sense because the levy permitted deductions only for
costs incurred in the mining operation, and not for expenses incident
to the general conduct of the business); Bank of America, 459 F.2d 513
(gross basis tax on income of banks did not qualify as an income tax
under section 901). The Treasury Department and the IRS do not agree
that a tax is properly considered a tax on net income so long as
empirical evidence demonstrates that the nonrecoverable costs and
expenses attributable to the gross receipts or gross income are almost
never so high as to eliminate any profit after the tax is paid. It is
unlikely, as a practical matter, that the data required to make such an
empirical showing of the amounts of disallowed expenses of all
taxpayers subject to the tax will be available to either taxpayers or
the IRS other than in the context of a targeted tax of narrow
application such as the levies considered in Texasgulf or Exxon. In any
event, such a gross basis tax is so dissimilar to the U.S. income tax
against which the foreign tax credit is allowed that the Treasury
Department and the IRS have determined it should not qualify as an
income tax in the U.S. sense. With respect to the comment that asserted
that gross basis digital services taxes never result in a loss to
affected companies, the fact that the comment failed to provide any
evidence may be indicative of the difficulty of making this empirical
showing. Furthermore, comments made by the affected industries have
made clear that gross basis taxes are inconsistent with the fundamental
nature of an income tax, and could in fact result in taxation of
companies that are in a loss position.\7\ Accordingly, the final
regulations largely maintain the approach of the 2020 FTC proposed
regulations in eliminating the nonconfiscatory gross basis tax rule.
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\7\ United States Trade Representative, Section 301
Investigation, Report on France's Digital Services Tax at 57-58
(Dec. 2, 2019), available at <a href="https://ustr.gov/sites/default/files/Report_On_France%27s_Digital_Services_Tax.pdf">https://ustr.gov/sites/default/files/Report_On_France%27s_Digital_Services_Tax.pdf</a> (quoting numerous
comments from digital companies and industry groups attesting that
the digital service taxes' application to revenue rather than income
is inconsistent with prevailing principles of international
taxation). In particular, a member from National Foreign Trade
Council stated that a ``tax imposed on gross revenue has no
relationship to net income or profits, which are the only proper
bases for a corporate income tax.'' Id. at 57. Another industry
representative stated that a ``tax on ordinary business profits,
imposed on gross revenue, has no relationship to net income. . . .
Gross revenue has no relationship to net income, and therefore such
taxes are not limited to taxing the gains of an enterprise, and will
drive companies into deeper losses if they are not profitable. Thus,
such a tax is likely to harm growing companies. . . .''). Id. at 58.
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However, upon consideration of the comments, the Treasury
Department and the IRS agree that a gross basis tax may meet the cost
recovery requirement if in fact there are no significant costs and
expenses attributable to the gross receipts included in the taxable
base. Accordingly, the final regulations at Sec. 1.901-2(b)(4)(i)(A)
remove the rule in the 2020 FTC proposed regulations that provided that
a gross basis tax could never meet the cost recovery requirement, even
if in practice there are no significant costs and expenses attributable
to the gross receipts included in the foreign tax base. Instead, Sec.
1.901-2(b)(4)(i)(A) provides that a gross basis tax satisfies the cost
recovery requirement if there are no significant costs and expenses
attributable to the gross receipts included in the foreign tax base
that must be recovered under the rules of Sec. 1.901-2(b)(4)(i)(C)(1).
In addition, the Treasury Department and the IRS recognize that the
Code contains various limitations on the recovery of non-business
expenses that have been modified from time to time. For example,
miscellaneous itemized deductions, including unreimbursed employee
expenses, are generally not deductible. Thus, the final regulations
provide in Sec. 1.901-2(b)(4)(i)(C)(2) that a foreign tax law that
does not permit recovery of costs and expenses attributable to wages
and investment income not derived from a trade or business satisfies
the cost recovery requirement. Furthermore, the final regulations
clarify in Sec. 1.901-2(b)(4)(i)(A) that a foreign tax need not permit
recovery of costs and expenses, such as certain personal expenses, that
are not attributable, under reasonable principles, to gross receipts
included in the foreign taxable base.
ii. Significant Costs
Proposed Sec. 1.901-2(b)(4)(i)(A) provided that the cost recovery
requirement is satisfied if the foreign tax law permits recovery of
significant costs and expenses attributable to the gross receipts
included in the foreign tax base. The significance of the cost is
determined based on whether, for all taxpayers in the aggregate to
which the foreign tax applies, the item of cost or expense constitutes
a significant portion of the taxpayers' total costs and expenses. See
proposed Sec. 1.901-2(b)(4)(i)(B)(2). In addition, proposed Sec.
1.901-2(b)(4)(i)(B)(2) specified that certain costs--such as costs or
expenses related to capital expenditures, interest,
[[Page 297]]
rents, royalties, services, and research and experimentation--are
always treated as significant, and thus, must be recoverable.
The 2020 FTC proposed regulations also addressed foreign expense
disallowance provisions. Proposed Sec. 1.901-2(b)(4)(i)(B)(2) provided
that a foreign levy that disallows recovery of all or a portion of a
significant cost or expense meets the cost recovery requirement if such
disallowance is consistent with the types of disallowances reflected in
the Code.
Several comments recommended that the Treasury Department and the
IRS retain the standard in the existing regulations and withdraw the
list of ``per se'' significant costs and expenses in proposed Sec.
1.901-2(b)(4)(i)(B)(2). Although some comments acknowledged the
rationale for adding the list of expenses that are always treated as
significant and thus must be recoverable, they also asserted that this
rule would create complexities because it would require continued
evaluation and re-evaluation of U.S. and foreign tax rules. One comment
noted that there could be changes to either the foreign tax law or the
U.S. tax law that could cause a foreign tax to be no longer creditable.
It suggested, as an example, that a foreign tax that includes rules
identical to current section 163(j), which took effect in 2018, would
have likely failed the cost recovery requirement in 2017 but would have
met the cost recovery requirement in 2018.
One comment recommended that if the per se list of recoverable
expenses is retained, it should apply only to taxpayers that in fact
incur a significant amount of such cost or expense, for example,
amounts in excess of a certain percentage of the particular taxpayer's
gross receipts. The comment recognized that its recommendation
conflicts with the rule in the existing and proposed regulations that a
foreign tax either satisfies or does not satisfy the definition of a
foreign income tax in its entirety, for all persons subject to the
foreign tax, but asserted that such a deviation is appropriate because
a taxpayer should not be denied a credit for a foreign tax because the
foreign law does not permit or limits recovery of an expense if the
particular taxpayer does not incur a significant amount of that
expense.
One comment questioned why the Treasury Department and the IRS
retained the empirical analysis in the definition of significance,
noting that it is contrary to the stated overall purpose of the
proposed modifications of the net gain requirement to minimize reliance
on empirical evidence.
Comments also disagreed with the policy of the 2020 FTC proposed
regulations of requiring foreign expense disallowance rules to be
consistent with U.S. disallowances. Comments noted that foreign
countries have different ways of structuring deduction disallowances
and different policy goals that they want to achieve through deduction
disallowances. One comment pointed to interest deduction disallowance
rules as an example, noting that the U.S. rules have a myriad of
restrictions on interest deductions, including because in certain
circumstances interest payments may reflect a return on capital. The
comment stated that if a foreign jurisdiction prohibits deductions for
interest payments in some or most circumstances because it views
interest as a return on capital, that could cause the foreign tax to be
no longer creditable. The comment asserted that a foreign levy should
not be non-creditable simply because the foreign jurisdiction has more
restrictive limitations on interest deductibility. Comments also
pointed to deduction disallowances for related-party interest payments,
noting that foreign governments may significantly restrict deductions
for interest incurred on related party debt. The comments contended
that such limitations would not be unreasonable, but that it is unclear
whether a foreign levy with such restrictions would be creditable under
the 2020 FTC proposed regulations. One comment further asserted that it
is unfair to disallow foreign tax credits when a foreign country adopts
disallowance provisions different from U.S. rules, because denial of
the credit results in double taxation of U.S. taxpayers that have no
control over the foreign country's policy decisions. Another comment
stated that the statute does not require strict conformity with U.S.
tax principles for a foreign tax to be creditable. Thus, foreign tax
law deviations from U.S. tax law should not cause a foreign levy to be
non-creditable unless the foreign law expense disallowances are so
pervasive as to make the foreign base not related to net income.
Comments also stated that the requirement that foreign cost
disallowances must be consistent with the types of disallowances in the
Code will lead to additional administrative burdens for the IRS and
compliance burdens for taxpayers because the 2020 FTC proposed
regulations provide insufficient guidance on the application of the
rule. Comments noted it is unclear the degree to which the foreign tax
disallowance rule must be similar to U.S. disallowance rules. The
comment also asked how temporary changes to the U.S. tax rules that are
intended to ameliorate shorter-term economic or policy concerns, such
as the changes to section 163(j) under the Coronavirus Aid, Relief, and
Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020), are
intended to affect the application of the rule. Similarly, another
comment noted that foreign countries may have a similar policy goal as
the United States but may adopt limitations, for example as part of the
BEPS initiative, on a different timeline than the United States.
Other comments noted that it is unclear if foreign expense
disallowance provisions that are not similar to disallowances under the
Code but that are necessitated by sound tax policy would cause a
foreign levy to be non-creditable under the 2020 FTC proposed
regulations. For example, one comment asked whether a foreign country
that permits full expensing of capital expenditures but disallows any
deduction for interest expense (which the comment asserts only avoids
economically duplicative deductions in the case of debt-financed
investments) would run afoul of the proposed rules because it is not
consistent with the disallowances in section 162 of the Code. A comment
queried whether disallowance of deductions under an alternative minimum
tax regime similar to section 55 or section 59A would be deemed
consistent with Federal income tax principles for purposes of the cost
recovery requirement. Comments recommended that if the proposed
modifications to the cost recovery requirement are finalized, the
Treasury Department and the IRS should provide additional examples
illustrating the application of the rule, including examples of
permissible disallowances as well as examples of disallowances that are
not identical to Federal income tax rules but are considered consistent
with U.S. tax principles.
After consideration of the comments, the Treasury Department and
the IRS have determined that the final regulations should generally
maintain the approach of the 2020 FTC proposed regulations, which
reflects the appropriate balance between accuracy and administrability
in determining whether the foreign tax law permits recovery of the
significant costs and expenses attributable to the gross receipts
included in the foreign taxable base. The costs and expenses that are
deemed significant under the 2020 FTC proposed regulations are those
costs and
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expenses that represent substantial deductions claimed by U.S.
taxpayers in computing the base of the U.S. income tax. Therefore, it
is reasonable to presume that those enumerated costs also reflect
substantial costs and expenses of taxpayers operating abroad. The
Treasury Department and the IRS have determined that it would be
impossible, as a practical matter, for either taxpayers or the IRS to
obtain both the private financial data and tax return data, for all
taxpayers subject to a generally-imposed foreign tax, that would be
needed to apply the empirical test of the existing regulations to
determine whether in fact all such taxpayers in the aggregate incurred
substantial costs and expenses for which deductions were not allowed in
determining the foreign taxable base. Accordingly, the final
regulations at Sec. 1.901-2(b)(4)(i)(C)(1) retain the requirement that
the foreign tax law by its terms must allow recovery of significant
costs and expenses, including recovery of costs and expenses related to
capital expenditures, interest, rents, royalties, wages or other
payments for services, and research and experimentation. In addition,
Sec. 1.901-2(b)(4)(i)(C)(1) clarifies that the foreign tax law applies
to determine the character of a particular deduction. For example, if a
foreign country denies a deduction for a payment made on an instrument
that is treated as equity for foreign tax purposes, the cost recovery
requirement is met even if the instrument is treated as debt for U.S.
tax purposes. In response to comments, Sec. 1.901-2(b)(4)(i)(C)(1)
also clarifies that foreign tax law that does not permit recovery of a
significant cost or expense (such as interest expense) is not
considered to allow recovery of such significant cost or expense by
reason of the time value of money attributable to the acceleration of a
tax benefit for a different expense (such as current expensing of
capital expenditures).
However, the Treasury Department and the IRS agree that the final
regulations should clarify the scope of permissible foreign tax law
expense disallowance rules. Accordingly, the final regulations include
additional rules and examples at Sec. 1.901-2(b)(4)(i)(C)(1) and Sec.
1.901-2(b)(4)(iv), respectively, illustrating that foreign tax law
rules need not mirror U.S. expense disallowance rules, but need only be
consistent with the principles reflected in U.S. tax law. For example,
Sec. 1.901-2(b)(4)(i)(C)(1) provides that a rule limiting interest
deductions to 10 percent of a reasonable measure of taxable income
(determined either before or after deductions for depreciation and
amortization) based on principles similar to those underlying section
163(j) would qualify.
iii. Alternative Allowance Rule
Under the ``alternative allowance rule'' in Sec. 1.901-2(b)(4) of
the existing regulations, a foreign tax that does not permit recovery
of one or more significant costs or expenses, but that provides
allowances that effectively compensate for nonrecovery of such
significant costs or expenses, is treated as meeting the cost recovery
requirement. The 2020 FTC proposed regulations modified the alternative
allowance rule to provide that an alternative allowance meets the cost
recovery requirement only if the foreign tax law, by its terms, permits
recovery of an amount that equals or exceeds the actual amounts of such
significant costs and expenses. See proposed Sec. 1.901-2(b)(4)(i)(A).
Several comments criticized the modification of the alternative
allowance rule and recommended that the Treasury Department and the IRS
retain the standard of the existing regulations. One comment asserted
that the proposed rules would cause a foreign levy to be non-creditable
even if the foreign levy provides an allowance that in fact equals or
exceeds the taxpayer's actual expenses; the comment contends that this
is arguably inconsistent with the language of the statute. Some
comments asserted that foreign levies are unlikely to meet the
requirement that the foreign tax law expressly guarantee that the
alternative allowance will equal or exceed actual costs because
alternative allowances are generally designed to avoid compliance
burdens related to the determination of actual costs. Thus, the
comments stated, the proposed rules could cause alternative tax regimes
that foreign countries impose to be non-creditable, even if those
regimes allow equivalent recovery of expenses in most if not all
circumstances.
Some comments disagreed with the statement in the preamble of the
2020 FTC proposed regulations that alternative allowances fundamentally
diverge from the approach to cost recovery in the Code; the comments
pointed out that the Code also has examples of alternative allowances
(citing to rules regarding travel expense reimbursement, the return on
intangible income for global intangible low tax income (``GILTI'') and
foreign-derived intangible income (``FDII''), the standard deduction,
and certain safe harbor methods for determining home office
deductions). Comments further stated that U.S. tax rules have allowed
the use of estimates of expenses in certain circumstances through, for
example, application of the ``Cohan rule'' (Cohan v. Comm'r, 39 F.2d
540 (2d Cir. 1930)), which permits courts to allow a tax benefit, such
as a deduction, if a taxpayer proves entitlement to a tax benefit but
fails to substantiate the exact amount of the benefit.
Some comments questioned the preamble's assertion that it is
difficult in practice for taxpayers and the IRS to determine whether an
alternative allowance under foreign tax law effectively compensates for
the nonrecovery of significant costs or expenses, noting that the
taxpayer was able to do so in Texasgulf. One comment asserted that many
court decisions show that a foreign levy that provides alternative
allowances for deductions can still be an income tax in the U.S. sense.
The comment did not cite any court decisions in support of this
assertion.
For the reasons explained in part IV.B.1 of this Summary of
Comments and Explanation of Revisions, the Treasury Department and the
IRS disagree with comments that the alternative allowance rule of the
existing regulations is an appropriate or administrable rule. In
addition, the use of percentages of the basis of certain tangible
property to compute income for GILTI and FDII purposes is
distinguishable from providing an alternative allowance in lieu of
actual costs and expenses to compute the taxable base because these
allowances are in addition to, and not in substitution for, provisions
in the Code that allow deductions for the actual costs and expenses
attributable to gross receipts included in the U.S. tax base. Moreover,
nothing in the final regulations precludes a foreign tax law from
allowing deductions in excess of those needed to recover the actual,
significant costs and expenses of earning taxable gross receipts.
Finally, the Cohan rule is a judicial doctrine that permits
approximating actual costs and expenses in limited circumstances where
the taxpayer demonstrates that it incurred a business expense but kept
inadequate records to substantiate the exact amounts of such expense.
Where a taxpayer can substantiate the actual amounts of its business
expenses, the Code allows those expenses as deductions. Thus, the Cohan
rule establishes a substantiation standard, but does not modify the
Code rule allowing actual costs and expenses to be recovered.
Accordingly, the final regulations retain the rule that a foreign
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tax law must permit the recovery of significant costs and expenses to
be an income tax in the U.S. sense.
However, the Treasury Department and the IRS recognize that some
foreign jurisdictions, in order to relieve administrative and
compliance burdens on certain small businesses, may provide an
alternative method for determining deductible costs attributable to
gross receipts, either as an optional alternative method or as the sole
method. As the comments noted, the Code contains alternative allowances
or safe-harbor rules for determining deductible business expenses in
limited circumstances. As a result, the final regulations at Sec.
1.901-2(b)(4)(i)(B)(1) provide that the cost recovery requirement is
satisfied if the foreign tax law allows the taxpayer to choose between
deducting actual costs or expenses or an optional allowance in lieu of
actual costs and expenses. In addition, the Treasury Department and the
IRS have determined that additional flexibility is warranted to
accommodate alternative allowances in lieu of actual cost recovery, if
the alternative measures are designed to minimize administrative or
compliance burdens with respect to small taxpayers. Accordingly, the
final regulations at Sec. 1.901-2(b)(4)(i)(B)(2) provide an exception
for these types of alternative allowances.
C. Tax in Lieu of Income Tax
1. In General
Section 903 provides that the term ``income, war profits, and
excess profits taxes'' includes a tax paid in lieu of a tax on income,
war profits, or excess profits that is otherwise generally imposed by
any foreign country. Under the 2020 FTC proposed regulations, a foreign
levy is a tax in lieu of an income tax only if (i) it is a foreign tax,
and (ii) it satisfies the substitution requirement. See proposed Sec.
1.903-1(b)(2). A foreign tax (the ``tested foreign tax'') satisfies the
substitution requirement, if based on the foreign tax law, it meets the
four requirements in proposed Sec. 1.903-1(c)(1): The generally-
imposed net income tax requirement, the non-duplication requirement,
the close connection requirement, and the jurisdiction-to-tax
requirement.
2. Generally-Imposed Net Income Tax Requirement
To meet the generally-imposed net income tax requirement, a
separate levy that is a net income tax (as defined in proposed Sec.
1.901-2(a)(3)) must be generally imposed by the same foreign country
(the ``generally-imposed net income tax'') that imposed the tested
foreign tax. Comments stated that the 2020 FTC proposed regulations
would unduly limit a foreign levy's qualification as a creditable ``in
lieu of tax'' by requiring the generally-imposed net income tax to
satisfy proposed Sec. 1.901-2, particularly as it has been revised to
require more similarity to U.S. tax principles. One comment further
explained that a tested foreign tax would not satisfy the generally-
imposed net income tax requirement with respect to a foreign
jurisdiction that limits the deductibility of interest under rules that
are inconsistent with the Code. Because these comments request
relaxation of the rules in proposed Sec. 1.901-2, as opposed to
changes to proposed Sec. 1.903-1, the responses to these comments are
addressed above at part IV.A of this Summary of Comments and
Explanation of Revisions, with respect to the jurisdictional nexus
requirement, and at part IV.B, with respect to the net gain
requirement.
3. Non-Duplication Requirement
Under the non-duplication requirement, neither the generally-
imposed net income tax nor any other net income tax imposed by the
foreign country may be imposed with respect to any portion of the
income to which the amounts that form the base of the tested foreign
tax relate (the ``excluded income''). A tested foreign tax does not
meet this requirement if a net income tax imposed by the same country
applies to the excluded income of any persons that are subject to the
tested foreign tax, even if not all persons subject to the tested
foreign tax are subject to the net income tax.
Comments asserted that the non-duplication requirement is
inconsistent with the interpretation of the substitution requirement in
Metropolitan Life Ins. Co. v. United States, 375 F. 2d 835 (Ct. Cl.
1967), which held that the Canadian premiums tax was ``in lieu of'' the
income tax for mutual life insurance companies, which were only subject
to the premiums tax, even though other types of insurance businesses
were subject to both the Canadian premiums tax and the generally-
imposed net income tax. As such, comments recommended that the non-
duplication requirement apply on a taxpayer-by-taxpayer basis, and any
loss of creditability of taxes paid should be limited to income that is
actually subject to both the generally-imposed net income tax and the
tested foreign tax.
Under the existing regulations, a foreign levy is either creditable
or not creditable for all taxpayers subject to the levy. This ``all or
nothing rule'' applies under existing Sec. 1.903-1 to the
determination of whether a foreign tax is an in lieu of tax. The 2020
FTC proposed regulations similarly provided as part of the non-
duplication requirement that a foreign levy that is imposed in addition
to the generally-imposed net income tax with respect to some taxpayers
is not a tax that is imposed in substitution for, or in lieu of, a
generally-imposed net income tax. The Treasury Department and the IRS
have determined that analyzing each tested foreign tax based on how it
applies to each taxpayer (instead of analyzing the tax as a whole)
would significantly increase compliance and administrative burdens for
taxpayers and the IRS. Moreover, allowing a tested foreign tax to
qualify as an in lieu of tax for any taxpayer when some taxpayers pay
both the tested foreign tax and the generally-imposed income tax on
income from the same activity is inconsistent with the notion that the
foreign country made a deliberate choice to create and impose a
separate levy instead of imposing the generally-imposed net income tax
on the excluded income. Accordingly, the final regulations retain the
``all or nothing'' rule in the non-duplication requirement.
Comments stated that it would be difficult for both the IRS and
taxpayers to determine how a tested foreign tax would apply to all
taxpayers subject to the levy, given that the tax can be applied on a
basis other than income. The 2020 FTC proposed regulations apply based
on the terms of the foreign tax law, not how the tax applies in
practice. To determine whether a tested foreign tax is creditable, the
taxpayer is not required to analyze how the tested foreign tax applies
on a taxpayer-by-taxpayer basis in practice, but instead is required
only to analyze the foreign tax law. Therefore, the provision is
finalized without change.
4. Close Connection Requirement
The close connection requirement in the 2020 FTC proposed
regulations requires that, but for the existence of the tested foreign
tax, the generally-imposed net income tax would otherwise have been
imposed on the excluded income. The requirement is met only if the
imposition of the tested foreign tax bears a close connection to the
failure to impose the generally-imposed net income tax on the excluded
income. A close connection exists if the generally-imposed net income
tax would apply by its terms to the income, but for the fact that the
excluded income is expressly excluded. Otherwise, a close connection
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must be established with proof that the foreign country made a
cognizant and deliberate choice to impose the tested foreign tax
instead of the generally-imposed net income tax. This proof must be
based on foreign tax law, or the legislative history of either the
tested foreign tax or the generally-imposed net income tax.
One comment suggested that the close connection requirement can be
read to be met only if the tested foreign tax applies to activities
that were initially subject to the generally-imposed net income tax and
then expressly excluded from its scope, and not if the activities
subject to the tested foreign tax were never within the scope of the
generally-imposed net income tax. The Treasury Department and the IRS
did not intend for the regulations to apply in this manner. Therefore,
the final regulations at Sec. 1.903-1(c)(1)(iii) clarify that a close
connection also exists if the generally-imposed net income tax by its
terms does not apply to the excluded income, and the tested foreign tax
is enacted contemporaneously with the generally-imposed net income tax.
Comments asserted that the close connection requirement goes beyond
the language of section 903, which comments maintained requires only
that the tested foreign tax be imposed in place of the generally-
imposed net income tax; not that the generally-imposed net income tax
would otherwise apply to the taxpayer. Comments also asserted that the
close connection requirement should be removed because the non-
duplication requirement is sufficient for ensuring that the tested
foreign tax does not duplicate the tax base of the generally-imposed
net income tax. Some comments also stated that the requirement that the
taxpayer provide proof that the generally-imposed net income tax
``would be imposed'' absent the tested foreign tax contradicts the
court's finding in Metropolitan Life.
The Treasury Department and the IRS have determined that the close
connection requirement is consistent with a reasonable construction of
the term ``in lieu of'' in section 903. According to Black's Law
Dictionary, ``in lieu of'' means ``to be instead of'' which implies a
connection between the imposition of the tested foreign tax and the
absence of a generally-imposed net income tax. Otherwise, the statute
would have provided that a credit would be allowed for any tax paid by
persons not subject to a generally-imposed net income tax. The mere
fact that two taxes may be mutually exclusive with respect to some
subset of taxpayers does not demonstrate that one is ``in lieu'' of the
other.
Furthermore, the requirement that taxpayers demonstrate a close
connection is consistent with the text of section 903 as well as court
decisions interpreting section 903. The Treasury Department and the IRS
disagree that the close connection requirement contradicts the court's
finding in Metropolitan Life. Rather, the ``close connection''
requirement is taken directly from Metropolitan Life, 375 F.2d at 839-
40 (``We have found `a very close connection between the imposition of
the Canadian premiums taxes involved here and the failure to impose
income taxes.' . . . The Canadian jurisdictions, we also found, made `a
cognizant and deliberate choice . . . between the application of
premiums taxes or income taxes for mutual life insurance companies.'').
Therefore, the comments are not adopted.
Other comments stated that the close connection requirement would
result in significant administrative burdens and uncertainties because
jurisdictions with less sophisticated legislative processes and tax
regimes may lack specific statutory language or legislative histories
to determine whether there was a close connection between the tested
foreign tax and the generally-imposed net income tax.
In response to the comments, the final regulations at Sec. 1.903-
1(c)(1)(iii) clarify that a close connection also exists if the
generally-imposed net income tax by its terms does not apply to the
excluded income, and the tested foreign tax is enacted
contemporaneously with the generally-imposed net income tax. Therefore,
legislative history is not always required to establish that the tested
foreign tax satisfies the close connection requirement.
5. Jurisdiction-to-Tax Requirement
The jurisdiction-to-tax requirement provides that if the generally-
imposed net income tax were applied to the excluded income, the
generally-imposed net income tax would either continue to qualify as a
net income tax under proposed Sec. 1.901-2(a)(3), or would constitute
a separate levy from the generally-imposed net income tax that would
itself be a net income tax under proposed Sec. 1.901-2(a)(3). One
comment noted that the reference to proposed Sec. 1.901-2(a)(3)
incorporates both the jurisdictional nexus requirement and the net gain
requirement. The comment questioned how a taxpayer can determine
whether a hypothetical generally-imposed net income tax would reach net
gain.
In response to the comment, the final regulations clarify that if
the generally-imposed net income tax, or a hypothetical new tax that is
a separate levy with respect to the generally-imposed net income tax,
were applied to the excluded income, such generally-imposed net income
tax or separate levy must meet the attribution requirement in Sec.
1.901-2(b)(5) but does not need to meet the other net gain requirements
contained in Sec. 1.901-2(b).
D. Separate Levy Determination
The 2020 FTC proposed regulations retained the general rule of the
existing regulations, which provides that whether a foreign levy is an
income tax for purposes of sections 901 and 903 is determined
independently for each separate foreign levy, but modified the rules to
clarify the principles used to determine whether one foreign levy is
separate from another foreign levy. See proposed Sec. 1.901-2(d)(1).
Proposed Sec. 1.901-2(d)(1)(ii) provided that separate levies are
imposed on particular classes of taxpayers if the taxable base is
different for those taxpayers.
One comment requested clarification of the treatment of a foreign
tax imposed on a distribution that is, in part, a dividend and, in
part, gives rise to capital gain. The comment noted that Sec. 1.861-
20(g)(5) includes an example that treats the tax imposed on the
dividend amount as a separate levy from the tax imposed on the capital
gain amount of the distribution, but it is unclear whether the separate
levy determination results from the fact that two different tax rates
apply to the same distribution, or because the taxes apply to two
different types of income. The comment recommended that the final rules
clarify the analysis for identifying separate levies in the case of
different taxable bases, or to elaborate on the policy considerations
underlying the separate levy rules.
One comment recommended that the Treasury Department and the IRS
further consider the application of the separate levy rules to minimum
tax regimes to ensure they do not prevent creditability of amounts that
would otherwise be treated as foreign income taxes. The comment noted
that if a regime imposes an incremental alternative minimum tax that
would not be creditable under section 901 or section 903, creditability
of the net income tax could depend on whether the two amounts are
considered separate levies.
Another comment stated that because the 2020 FTC proposed
regulations require separate determinations of
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creditability for each class of taxpayers for which the application of
the foreign levy results in a significantly different tax base (rather
than determining whether a foreign levy applies to net income in the
normal instance), the application of the separate levy rules and the
net gain requirements is complex. It stated that the determination of a
separate levy is both fact intensive and nuanced because all deviations
from the ``pure'' income tax system of the Code will have to be
identified and some deviations will create a separate class of
taxpayers (and therefore a separate levy) while other deviations would
simply have to be weighed for significance.
The Treasury Department and the IRS have determined that additional
clarification of the separate levy rules is not needed in connection
with the example in Sec. 1.861-20(g)(5), because the rules for
allocating and apportioning the foreign income tax on the facts of the
example would be the same whether the tax on the foreign law dividend
and capital gain amounts was imposed pursuant to a single levy or
separate levies. However, in response to comments, the final
regulations at Sec. 1.901-2(d)(3) provide additional examples to
illustrate the application of the separate levy rules to minimum tax
regimes and other foreign tax regimes involving separate levies that
include some common elements. In particular, Sec. 1.901-2(d)(3)(ix)
(Example 9) illustrates that a foreign tax containing a limitation on
interest deductions that applies only to one class of taxpayers subject
to the tax does not cause the tax to be treated as a separate levy as
to that class of taxpayers.
E. Amount of Tax That Is Considered Paid
1. Refundable Credits
The 2020 FTC proposed regulations modified Sec. 1.901-2(e)(2)(ii)
of the existing regulations to provide explicit rules regarding the
effect of foreign law tax credits in determining the amount of tax a
taxpayer is considered to pay or accrue. Proposed Sec. 1.901-
2(e)(2)(ii) provided that a tax credit allowed under foreign law is
considered to reduce the amount of foreign income tax paid, regardless
of whether the amount of the tax credit is refundable in cash to the
extent it exceeds the taxpayer's liability for foreign income tax.
Proposed Sec. 1.901-2(e)(2)(iii) provided an exception to this rule
for credits in respect of overpayments of a different tax liability
that are refundable in cash at the taxpayer's option and applied to
satisfy the taxpayer's foreign income tax liability.
While one comment agreed with the rule in proposed Sec. 1.901-
2(e)(2), other comments disagreed with the proposed rule, including the
example illustrating these rules in proposed Sec. 1.901-
2(e)(4)(ii)(A), asserting that refundable tax credits should be treated
as government grants administered through the foreign country's tax
system. Under that view, refundable tax credits should be treated as a
constructive payment of cash to the taxpayer that the taxpayer uses to
constructively pay the amount of foreign income tax liability that is
offset or satisfied by application of the tax credit. These comments
argue that refundable tax credits provide an economic benefit that is
not tied to taxable income or tax liability, which is similar to a
government grant and unlike non-refundable tax credits or subsidies
described in section 901(i). They further argue that accounting
standards under IFRS and GAAP, as well as OECD commentary, treat
refundable tax credits as a government expenditure, and that the IRS
has issued guidance in the past that suggests that refundable tax
credits may be deemed to satisfy, rather than reduce, a foreign tax
liability (TAM
[…truncated; see source link]Indexed from Federal Register on January 4, 2022.
This is legal information, not legal advice. Laws vary by jurisdiction and change frequently. Always verify current law with official sources and consult a licensed attorney in your jurisdiction for advice on your specific situation.