Proposed regulations provide guidance on foreign tax credit rules

By Martha Waggoner

Treasury issued proposed regulations (REG-112096-22) relating to the foreign tax credit (FTC) on Friday, including revisions to the reattribution asset rule for purposes of allocating and apportioning foreign taxes, the cost recovery requirement, and the application of the source-based attribution requirement to withholding tax on royalty payments.

Reattribution asset rule

The 2022 FTC final regulations provide rules for allocating and apportioning foreign income tax arising from a disregarded payment. Regs. Sec. 1.861-20(d)(3)(v) characterizes a disregarded payment under federal income tax law for purposes of assigning foreign gross income to various statutory and residual groupings.

Under these rules, a portion of a disregarded payment, if any, that causes U.S. gross income of the payer to be reattributed under either Regs. Sec. 1.904-4(f)(2) (in the case of a taxpayer that is an individual or domestic corporation) or Regs. Sec. 1.951A-2(c)(7)(ii)(B) (in the case of a taxpayer that is a foreign corporation) to the recipient is treated as a "reattribution payment." 

The Regs. Sec. 1.861-20(d)(3)(v)(C)(1)(ii) reattribution asset rule requires that when there is reattribution of income from a payer to a recipient, there must also be a reattribution of the tax book value of the payer's assets that generated the reattributed income from the payer to the recipient.

Treasury and the IRS agreed that the reattribution asset rule is not needed for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, particularly when it involves disregarded sales of inventory property.

Thus, Prop. Regs. Sec. 1.861-20(d)(3)(v)(E)(6) retains the general definition of reattribution asset but is revised to exclude any portion of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable units,"

Cost recovery rule

Generally, a foreign tax satisfies the cost recovery requirement of Regs. Sec. 1.901-2(b)(4)(i)(A) if the base of the tax is computed by reducing gross receipts to permit recovery of significant costs and expenses (including capital expenditures) attributable, under reasonable principles, to those gross receipts. However, Treasury and the IRS received requests to modify the cost recovery requirement after the 2022 FTC final regulations were published.

In response, the proposed regulations include:

  • Prop. Regs. Sec. 1.901-2(b)(4)(i), which retains the general cost recovery requirement under the 2022 FTC final regulations but provides that the relevant foreign tax law need only permit recovery of substantially all of each item of significant cost or expense. Whether a foreign tax permits recovery of substantially all of each item of significant cost or expense is determined based solely on the terms of the foreign tax law.
  • Prop. Regs. Sec. 1.901-2(b)(4)(i)(C)(2), which provides a safe harbor for purposes of applying the cost recovery requirement, under which a disallowance of a stated portion of an item (or multiple items) of significant cost or expense does not prevent a foreign tax from satisfying the cost recovery requirement if the portion of the item (or items) that is disallowed does not exceed 25%, along with other limits.

Attribution requirement for royalty payments

Under the 2022 FTC final regulations' source-based attribution requirement, a foreign tax imposed on a nonresident's income on the basis of source meets the attribution requirement only if the foreign tax law's sourcing rules are reasonably similar to the sourcing rules that apply for federal income tax purposes (Regs. Sec. 1.901-2(b)(5)(i)(B)). After the 2022 FTC final regulations were published, Treasury and the IRS received requests to change the application of the source-based attribution requirement to certain royalty withholding taxes by allowing a credit even if a foreign country sources royalties based on the residence of the payer or by applying a different standard.

They concluded that it is right to provide a limited exception to the source-based attribution requirement when the taxpayer can show that a withholding tax is imposed on royalties received in exchange for the right to use intangible property solely within the territory of the taxing jurisdiction.

This new limited exception is reflected in Prop. Regs. Sec. 1.903-1(c)(2)(iii), which provides that a tested foreign tax will satisfy the source-based attribution requirement if it meets the "single country exception" in Prop. Regs. Sec. 1.903-1(c)(2)(iii)(B). The single country exception applies where:

  1. the income subject to the tested foreign tax is characterized as gross royalty income, and
  2. the payment giving rise to such income is made pursuant to a single-country license.

Also, Prop. Regs. Sec. 1.903-1(c)(2)(iii)(B), provides that foreign tax law generally applies for purposes of determining whether the gross income or gross receipts arising from a transaction are characterized as a royalty, except in the case of a transaction that is considered the sale of a copyrighted article under Regs. Sec. 1.861-18, which is not treated as a license of intangible property but as a sale of tangible property.

In addition, a payment is made pursuant to a single-country license if the terms of the written license agreement under which the payment is made characterize the payment as a royalty and limit the territory of the license to the foreign country imposing the tested foreign tax under Proposed Reg. Sec. 1.903-1(c)(2)(iv)(A).

The proposed regulations are generally proposed to apply to tax years ending on or after the date of their publication in the Federal Register. However, once they are finalized, taxpayers will be able to choose to apply the final regulations to earlier tax years, subject to some conditions. Prop. Regs. Sec. 1.861-20(d)(3)(v)(E)(6), regarding the definition of a reattribution asset, is proposed to apply to tax years ending on or after the date the regulations are finalized. Taxpayers can generally rely on the proposed regulations before they are finalized, subject to certain conditions.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.

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