U.S. Treasury Issues Proposed Regulations to Final Foreign Tax Credit Regulations
The U.S. Department of the Treasury on November 18 released proposed foreign tax credit (FTC) regulations that provide additional guidance on several key areas of the 2021 final FTC regulations, most notably the cost recovery requirement and the attribution requirement for royalty withholding tax. Both areas have created concern for taxpayers since the 2021 final FTC regulations were issued in December 2021. The 2022 proposed FTC regulations set forth two new safe harbor tests in an effort to reassure taxpayers that some of their foreign taxes should still be eligible for a U.S. FTC.
The 2022 proposed FTC regulations also remove the reattribution asset rule for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, and with respect to disregarded sales of inventory property.
Cost Recovery Requirement
The cost recovery requirement, an element of the net gain requirement in the 2021 final FTC regulations, requires a foreign country to permit the recovery of significant costs and expenses attributable to gross receipts in order for a foreign tax to be creditable in the U.S. The 2021 final FTC regulations provide a list of per se significant costs and expenses, such as wages, capital expenditures, royalties and rents.
The 2022 proposed FTC regulations generally retain the cost recovery requirement; however, they make clear that relevant foreign tax law need only permit recovery of substantially all of each item of significant cost or expense.
In addition, the 2022 proposed FTC regulations set forth a safe harbor to aid in determining whether a foreign tax meets the cost recovery requirement. Specifically, the disallowance of a portion of an item or items of significant cost or expense cannot exceed 25% in order to meet the safe harbor. If, however, foreign tax law caps deductions of a single item of significant cost or expense or multiple items that relate to a single category of per se significant costs and expenses, the safe harbor will be satisfied as long as the cap, based on foreign tax law, is at least 15% of gross receipts or gross income (or a similar base) or 30% of taxable income (or a similar base).
If the safe harbor is not met, but the foreign tax law contains a disallowance that otherwise prevents the recovery of substantially all of an item of significant cost or expense, then the disallowance would need to be analyzed under the already existing principles-based exception. This exception ultimately provides that the disallowance must be consistent with any principle under the U.S. Code or a non-tax public policy concern in order to meet the cost recovery requirement.
Royalty Attribution Requirement
The 2021 final FTC regulations added the attribution requirement as an additional element of the net gain requirement to permit a foreign tax to be creditable only if the country imposing the tax has sufficient nexus to the taxpayer’s activities. Specifically, for foreign royalty withholding tax, the foreign country’s sourcing rule would generally have to follow that of the U.S., which is based on where the intellectual property (IP) is used.
The 2022 proposed FTC regulations set forth a proposed safe harbor that allows taxpayers to satisfy the attribution requirement when foreign withholding tax is imposed on royalties received in exchange for the right to use IP solely within the territory of the taxing jurisdiction (the so-called “single-country exception”). This exception applies when (1) the income subject to the foreign tax is characterized as gross royalty income based on foreign tax law; and (2) the payment giving rise to such income is made pursuant to a single-country license.
To satisfy the safe harbor, the taxpayer must have a written license agreement in place that provides for the payment of the royalty and that limits the use of the IP giving rise to the royalty payment to the territory of the foreign country imposing the tax. If the agreement does not limit the territory, it must separately state the portion of the payment subject to the foreign tax that is a royalty and subject to tax in that territory.
Subject to an anti-abuse rule, for royalties paid on or before May 17, 2023, the 2022 proposed FTC regulations provide a transition rule that allows taxpayers to satisfy the documentation requirement by executing the required agreement no later than May 17, 2023. The agreement must state that royalties paid on or before the execution of the agreement are considered paid pursuant to the terms of the agreement.
Withholding tax imposed on a royalty payment made to a nonresident pursuant to a single-country license is also determined to be a separate levy from a withholding tax imposed on other royalty payments made to that nonresident.
The 2022 proposed FTC regulations have various applicability dates; however, subject to certain consistency rules, taxpayers can choose to apply them retroactively once they have been finalized. Until that time, the 2022 proposed FTC regulations may be relied upon (under certain conditions).
How We Can Help
Although the 2022 proposed FTC regulations have not been finalized, taxpayers should begin considering this new favorable guidance when analyzing the effects of the 2021 final FTC regulations on their FTC calculations. Additionally, royalty agreements should be revisited and reviewed to ensure that they meet the documentation requirements set forth in the 2022 proposed FTC regulations prior to the transition rule deadline.
The FTC rules and final regulations are highly complex. We can help multinational taxpayers navigate these rules, regulations, and guidance to ensure compliance and help identify growth opportunities.