The Treasury and IRS have issued final regulations affecting taxpayers that claim credits or deductions for foreign income taxes or claim a deduction for foreign derived intangible income (FDII). The regulations finalize 2020 proposed regulations (REG-101657-20) and address:
- the disallowance of a foreign tax credit or deduction for foreign income taxes under Code Sec. 245A(d);
- the determination of oil and gas extraction income from domestic and foreign sources and of electronically supplied services under the Code Sec. 250 regulations;
- the impact of the repeal of Code Sec. 902 on certain regulations issued under Code Sec. 367(b);
- the sourcing of inclusions under Code Secs. 951, 951A, and 1293; the allocation and apportionment of interest deductions of certain regulated utilities;
- a revision to the controlled foreign corporation (CFC) netting rule;
- the allocation and apportionment of Code Sec. 818(f)(1) items of life insurance companies that are members of consolidated groups;
- the allocation and apportionment of foreign income taxes, including taxes imposed with respect to disregarded payments;
- the definitions of a foreign income tax and a tax in lieu of an income tax;
- the allocation of the liability for foreign income taxes in connection with certain mid-year transfers or reorganizations;
- the foreign branch category rules in Reg. §1.904–4(f); and
- the time at which credits for foreign income taxes can be claimed pursuant to Code Secs. 901(a) and 905(a).
The regulations are effective on March 7, 2022, and contain a number of specific applicability dates.
Foreign Tax Credit
The final regulations address a number of issues with respect to the foreign tax credit, including the definition of a foreign tax credit for purposes of the creditability of foreign income taxes under Code Sec. 901 and Code Sec. 903. These issues include the jurisdictional nexus requirement, the net gain requirement, tax in lieu of income tax, separate levy determination, and the amount of tax that is considered paid. The final regulations also address when the foreign tax credit may be claimed, including the treatment of contested foreign income taxes.
The jurisdictional nexus requirement in the proposed regulations is adopted and renamed the attribution requirement. The foreign tax law must require a sufficient nexus between the foreign country and the taxpayer’s activities or investment of capital or other assets that give rise to the income being taxed. The foreign tax imposed on a nonresident must be based on the nonresident’s activities located in the foreign country (including its functions, assets, and risks located in the foreign country) without taking into account as a significant factor the location of customers, users, or similar destination-based criteria.
Under the final regulations, a tax in lieu of an income under Code Sec. 903 must also meet the jurisdictional nexus requirements.
To be creditable under current regulations, a foreign tax must reach net gain (i.e., meet realization, gross receipts, and net income tests). Under these regulations, a gross basis tax may be creditable if it is shown that the tax as applied does not result in taxing more than the taxpayer’s profit. The IRS may request country-level or other aggregate data to analyze whether the tax reaches net gain. The tax is creditable or not creditable based on its application to all taxpayers rather than on a taxpayer-by-taxpayer basis.
Under the final regulations, in applying the net gain requirements, the terms of the foreign tax law are relied upon. For a foreign tax to be creditable, the tax must generally be levied upon realized gross receipts (and certain deemed gross receipts) net of deductions for expenses. The use of data to demonstrate that an alternative base upon which the tax is levied is in practice a gross receipts equivalent cannot be used to satisfy the gross receipts portion of the net gain requirement. Data-driven conclusions are used only for portions of the realization or cost recovery requirement.
The separate levy determination under the current and final regulations provides that whether a foreign levy is an income tax is determined independently for each separate levy. Rules are provided under the final regulations for determining whether one foreign levy is separate from another.
Explicit rules are also provided for determining the effect of foreign law tax credits on the amount of tax a taxpayer is considered to pay or accrue.
The final regulations provide that contested taxes do not accrue until the contest is resolved. A taxpayer may, however, claim a provisional credit for the portion of taxes already remitted to the foreign government. The taxpayer must agree to notify the IRS when the contest concludes and not to assert the statute of limitations as a defense to assessment of U.S. tax if the IRS determines that the taxpayer failed to take appropriate action to get a refund.
Reg. §1.250(b)-5 provides rules for determining whether services are provided outside of the United States and give rise to foreign derived deduction eligible income (FDDEI service). Special rules apply to electronically supplied services. An electronically supplied service is a general service, other than advertising, delivered primarily over the internet or an electronic network. These services include cloud computing and digital streaming services. The proposed regulations revised the definition of electronically supplied service to clarify that value of the service to the end user must be derived primarily from the service’s automation and electronic delivery. The final regulations also clarify that the services must not primarily depend on human effort.