Treasury Finalizes Foreign Tax Credit Regulations, Including Novel Jurisdictional Nexus (Attribution) Rule
By:
On December 28, 2021, Treasury and the IRS (collectively, Treasury) submitted another package of final foreign tax credit regulations for publication, T.D. 9959, 87 FR 276 (Final Regulations). The Final Regulations are important. They finalize many of the November 2020 proposed regulations, as well as a few older proposed rules, without significant changes. In a few places, they also make important changes and additions.
Over the objections of numerous commentators, including the authors, Treasury retained the proposed “jurisdictional nexus” requirement, re-branded as the “attribution” requirement in the Final Regulations. Whatever its name, this novel requirement purports to deny foreign tax credits for a large swath of foreign income taxes, without any support in the §901 statute or judicial decisions interpreting it. The Final Regulations also add a surprising new twist to the requirement: A royalty source rule that is sure to raise issues for multinationals.
The final rules also address a range of other foreign tax credit issues. Among other things: They revise the longstanding “net gain” rules under §1.901-2(b) in an effort to reverse the U.S. Supreme Court’s decision in PPL Corp. v. Commissioner; they expand the circumstances in which foreign income taxes must be allocated between taxpayers under §1.901-2(f) as a result of a mid-year transaction, including a mid‑year check‑the‑box election; they add important details to the “voluntary payment” rules under §1.901-2(e)(5)(i); and they codify, expand and in some cases alter the timing rules for when foreign income taxes may be claimed as credits under §1.905-1.
The final regulations appeared in the Federal Register on January 4, 2022. Some of the new rules are retroactive. With few exceptions, the rest, including the attribution (jurisdictional nexus) rule, are effective for taxable years beginning on or after December 28, 2021. U.S.-based multinationals will need to give these rules some significant attention in 2022, to comply with financial reporting requirements, and to prepare for the next wave of IRS audits.
With the new attribution rule, §1.901-2(b)(5), Treasury has taken the position that in order to qualify as an income tax, not only must a foreign tax meet the traditional realization, gross receipts, and cost recovery tests (as modified by the Final Regulations), the foreign tax must also be sufficiently similar to the U.S. federal income tax—under standards chosen by Treasury. The attribution rule applies differently to foreign taxes imposed on residents of the taxing jurisdiction and those imposed on nonresidents.
In the case of a foreign tax imposed on nonresidents, the attribution rule requires that the gross receipts and costs attributable to each of the items of income included in the foreign tax base must satisfy one of three possible jurisdictional nexus tests: The activities test, the source test, or the situs test.
Under the activities test, the gross receipts and costs included in the base of the foreign tax must be attributable, under reasonable principles, to a nonresident’s activities within the foreign country imposing the tax (including the nonresident’s functions, assets, and risks located in the country). Reasonable principles include rules similar to those for determining ECI, but do not include rules that take into account as a significant factor the mere location of customers, users or any other similar destination-based criterion, or the mere location of persons from whom the nonresident makes purchases.
Under the source test, the income included in the foreign tax base must be determined on the basis of source-of-income rules that are reasonably similar to the source‑of‑income rules in the Code. If that is not offensive enough, the source test goes on to proclaim that certain foreign law source rules must mirror the Code rules: A foreign law source rule for services will only be considered reasonably similar if it is based on where the services are performed, and, in a surprising twist added by the Final Regulations, a foreign law source rule for royalties will only be considered reasonably similar if it is based on the place of use of (or the right to use) the intangible. The source test is incorporated by reference in the Final Regulations on “in lieu of” taxes under §1.903-1, and plays an important role in evaluating the creditability of a foreign withholding tax.
Section 1.903-1(d), Example 4, suggests that in the absence of a treaty (see discussion below), or in the case of a foreign tax imposed on a CFC, the government intends to apply the attribution rule strictly. In the example, USP owns YCo, a Country Y CFC. YCo licenses IP to unrelated XCo, a Country X corporation, for worldwide use. Under Country X tax law, all royalties paid by a Country X resident to a nonresident are sourced to Country X and subject to a 30% withholding tax. XCo uses the IP solely in Country X and pays YCo 100 of royalties, which are subject to 30 of Country X withholding tax. The example concludes that none of the withholding tax is creditable, because Country X’s source rule for royalties (residence of the payor) is not reasonably similar to the Code’s rule (place of use). Apparently, it is irrelevant that the withholding tax would have been the same if Country X had a place-of-use source rule. The example states that since the Country X source rule is not based on place of use, that’s the end of the inquiry.
In the case of sales of property, including sales of copyrighted articles, the source test is unavailable, and a foreign tax on nonresidents can only satisfy the attribution rule under the activities test or the situs test.
Under the situs test, a foreign tax imposed on a nonresident’s gain from the sale of property that is based on the situs of the property must be attributable to gross receipts from the disposition of real property located in the foreign country, or an interest in a resident entity that owns the real property, under rules reasonably similar to the U.S. FIRPTA rules.
In the case of a foreign tax imposed on residents of the taxing jurisdiction, the attribution rule allows the foreign tax base to be computed based on worldwide income, but requires that any allocation of income, gain, loss or deduction with respect to transactions between the resident and related persons under the foreign country’s transfer pricing rules must be determined under arm’s length principles, again without taking into account as a significant factor the location of customers, users or any other similar destination‑based criterion.
Treas. Reg. §1.901-2(a)(1)(iii) provides an important treaty exception in the case of foreign taxes paid or accrued by a U.S. taxpayer. Foreign taxes that are treated as income taxes under the relief from double taxation article of a U.S. treaty are treated as foreign income taxes, and creditable, if they are paid or accrued by a U.S. citizen or resident that elects benefits under the treaty. A far more limited rule applies in the case of foreign taxes paid or accrued by CFCs: Any limitations in the treaty between the taxing country and the CFC’s country are taken into account in determining whether the foreign tax imposed on the CFC meets the attribution rule.
The Final Regulations under §1.903-1 establish a special version of the attribution rule for testing a non-withholding tax that is not an income tax but is imposed in lieu of a generally imposed net income tax. The attribution rule is applied to the income tax, and to the income that is not taxed under the income tax because it is instead taxed under the tested Section 903 tax (the excluded income). If the income tax would continue to satisfy the attribution rule when also applied to the excluded income, or if, as applied to the excluded income, would be treated as a separate levy that satisfies the rule, then the tested Section 903 tax is treated as satisfying the rule. (Other changes to §1.903-1 are discussed below.)
These rules apply to foreign taxes paid or accrued in tax years beginning on or after December 28, 2021. In the case of the Puerto Rico excise tax, they apply to tax years beginning on or after January 1, 2023.
In the Final Regulations preamble, Treasury goes to great lengths to justify the attribution rule, but the justifications ring hollow. Section 901 isn’t complicated. In it, Congress has provided a credit for income taxes paid to a foreign country. “Income taxes” are taxes on income. It’s that simple. Treasury can provide guidance around the edges, addressing when a tax is imposed on income, and when it is imposed on something else, like value, capital, or outlays. This, of course, is what the old §1.901-2 regulations (1983 Regulations) did. With the attribution rule, Treasury has ventured much further, stepping into the legislative arena—without authority to do so. There is no jurisdictional nexus requirement in §901. There is no requirement that a foreign income tax must be “similar” to our federal income tax. Under the plain meaning of the law, the foreign tax need only be an “income tax” to be creditable.
Treasury asserts that it is merely applying the Biddle concept that foreign taxes must be income taxes “in the U.S. sense” to qualify as foreign income taxes. But Treasury twists this phrase into an unrecognizable form, concluding that a foreign tax can only be an income tax “in the U.S. sense” if it is similar to the federal income tax. That is clearly not what Biddle said. An income tax in the U.S. sense simply means that the foreign tax must be an income tax, i.e., a tax on income, as that concept is understood under U.S. principles. There is not, and never was, a requirement that foreign law must resemble (or worse yet, strictly mirror) the Internal Revenue Code for the foreign taxes to be considered income taxes.
Treasury asserts that the attribution requirement is necessary because other countries have “abandoned international norms” with new kinds of taxes, like digital services taxes. But it’s not Treasury’s place to make that decision by changing the fundamental operation and application of §901. And the new requirements go well beyond digital services taxes. Under the attribution rule, every foreign income tax will need to be examined, and a number of countries may not have provisions that are reasonably similar to, or in some cases exactly the same as, the Internal Revenue Code. Indeed, U.S. tax rules are in some ways unique since the United States is one of the few countries that taxes worldwide income.
As one illustration, §1.903-1(d), Example 4, discussed above, suggests that any foreign withholding tax on royalties will fail the attribution rule where the foreign country’s source rule isn’t place‑of‑use. Is the same true for any foreign tax on services income where the foreign country’s source rule isn’t place‑of‑performance? Or a foreign tax on the gain derived from the sale of an in-country company’s stock? These kinds of foreign income taxes have been around for a long time, and in many countries. Treasury has implicitly endorsed many of them in the context of U.S. bilateral income tax treaties.
Besides jurisdictional nexus, the proposed regulations modified a number of other longstanding rules on what is required for a foreign tax to be creditable. The Final Regulations largely finalize the rules as proposed, with a few modest changes.
Notwithstanding the objections of commentators and the contrary Supreme Court decision in PPL, Treasury insisted on removing the predominant character rule from the regulations. That longstanding rule provides that the determination of whether a foreign tax is an income tax is made based on the tax’s predominant character, in the normal circumstances in which it applies. Again, Treasury set forth a lengthy defense of this change in the preamble, arguing that PPL merely interpreted the 1983 Regulations, and that Treasury can change its regulations if it wishes. However, the Supreme Court in PPL stated that the 1983 Regulations “codify” longstanding doctrine, and it referred to the regulations as “confirming” the rules as laid down over the preceding decades. Treasury can change its regulations. But it can’t change the law by first writing a regulation that restates the law, and then writing a new regulation that changes the law.
In place of the predominant character test, §1.901-2(b) now provides that the net gain requirement is applied “solely on the basis of the foreign tax law governing the calculation of the foreign tax base,” except where the Final Regulations provide otherwise. Despite the general form-over-substance approach, a faint echo of the predominant character test can still be heard in the Final Regulations’ restatement of the realization requirement: The taxation of nonrealization events will not disqualify a foreign tax if the incidence and amounts of gross receipts attributable to those events are relatively insignificant “as judged based on the application of the foreign tax to all taxpayers” subject to the tax.
With respect to the gross receipts requirement, in response to comments, the Final Regulations preserve, but only to a degree, the 1983 Regulations’ “alternative gross receipts test.” Under that test, a foreign tax met the gross receipts requirement if it was 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. A foreign tax will now meet the gross receipts test only if the tax is imposed on actual gross receipts, on deemed gross receipts arising from pre-realization timing difference events, or on the basis of gross receipts from an insignificant nonrealization event. In keeping with this stricter standard, the Final Regulations modify the example involving the “cost-plus tax” on regional headquarters companies, to provide that the tax does not meet the gross receipts test.
The Final Regulations also largely implement the proposed rules tightening the cost recovery requirement. Section 1.901-2(b)(4) now provides, in general, that a foreign tax satisfies the cost recovery requirement only if the foreign tax allows for the recovery of all of the following significant costs and expenses: Interest, rents, royalties, wages, other payments for services, R&D expenses and costs for capital expenditures. Exceptions are possible, but only if a disallowed expense deduction “is consistent with the principles underlying the disallowances” under the Code. Again, Treasury’s distorted conception of an income tax “in the U.S. sense” is on display. The new rules turn the traditional idea of “significant costs and expenses” on its head, changing it from a flexible standard into a rigid set of requirements.
The Final Regulations make some small concessions to comments on cost recovery. They provide 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 are required to be recovered as significant costs and expenses under the Final Regulations (see the list above). They also preserve, to some degree, the 1983 Regulations’ “alternative allowance rule.” Under the Final Regulations, 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. Taxpayers are warned, however, that choosing the optional allowance could run afoul of the “compulsory payment” rule, discussed below. The Final Regulations also graciously allow foreign law to provide alternative cost recovery rules for small businesses.
These rules also apply to foreign taxes paid or accrued in tax years beginning on or after December 28, 2021. In the case of the Puerto Rico excise tax, they apply to tax years beginning on or after January 1, 2023.
The determination of whether a particular foreign tax is creditable is made separately for each separate foreign levy. In applying the net gain requirements, it can be relevant whether a given tax is a separate levy (which may be non-creditable) or a mere difference in the tax base of a single levy (which is either creditable or non-creditable in its entirety). The Final Regulations modify the 1983 Regulations, attempting to provide some clarification through additional principles and several specific examples.
Under the Final Regulations, §1.901-2(d), certain differences in taxes automatically lead to separate levies: (1) levies imposed by different subdivisions of a foreign government; (2) levies that are imposed only on nonresidents; (3) levies that are modified by the terms of an applicable income tax treaty; and (4) levies that are modified by a contract with the foreign country. Under these rules, for example, a foreign tax equivalent to the U.S. tax on nonresidents earning ECI would be considered a separate levy even if the base of the tax were the same as the corporate income tax applied to residents.
Two levies are also considered separate if the tax base is computed separately for different persons subject to the tax. On the other hand, two foreign tax laws do not give rise to separate levies merely because there are different rates or special provisions applicable only to certain persons subject to the tax. The line between these two situations will be a difficult one to implement.
Two examples in the Final Regulations address situations that have arisen in practice. Section 1.901-2(d)(3), Example 6 addresses a foreign corporate minimum tax that applies to taxable income adjusted to remove certain deductions. Because the tax base of the minimum tax is computed separately from that of the regular corporate income tax, it is considered a separate levy. The Example states that the result would be the same if the minimum tax, like the U.S. AMT or BEAT, only applied to the extent it exceeded the regular tax.
Example 7 concludes that a tax styled as a “diverted profits tax” (DPT) is also a separate levy. Like the U.K. DPT, the tax in the example applies to gross receipts and deductions attributed to a hypothetical PE of a nonresident. The computation of tax on the profits of the hypothetical PE relies on the regular corporate tax rules. However, since the tax base of the DPT is different and because it only applies to nonresidents, the DPT is considered a separate levy.
These rules generally apply to foreign taxes paid or accrued in tax years beginning on or after December 28, 2021.
The Final Regulations also provide guidance on foreign tax refunds. Under the 1983 Regulations, a foreign tax refund that is reasonably certain to be received would reduce the amount of foreign tax for which a credit can be claimed.
In §1.901-2(e)(2), the Final Regulations retain that rule and provide additional rules for refundable and non-refundable tax credits in a foreign country. Generally, unless it exceeds the taxpayer’s tax liability, a non-refundable credit is treated as a reduction of the foreign tax liability for which the credit can be claimed. On the other hand, if the taxpayer may elect at its option to receive the credit in cash, the application of the credit to satisfy another foreign tax liability is a constructive payment of that liability. For example, this would seem to apply if the taxpayer had an overpayment of corporate income tax for Year 1 and, instead of receiving the refund in cash, elected to apply the overpayment to corporate income taxes payable for Year 2, similar to a credit-elect under §6402(b).
These rules generally apply to foreign taxes paid or accrued in tax years beginning on or after December 28, 2021.
The Final Regulations also modify, and expand on, the rules for compulsory payments in §1.901-2(e)(5). The 1983 Regulations provided that an amount paid to a foreign country is not a compulsory payment, and thus is not an amount of tax paid, to the extent it exceeds the amount of liability for tax under foreign law. The proposed regulations added the word “income,” providing that an amount paid is noncompulsory, and thus is not an amount of income tax paid, to the extent it exceeds the amount of liability for income tax under foreign law. The proposed rules also would have required taxpayers to take reasonable steps to minimize their foreign income tax liability, taking into account the reasonably expected costs of doing so.
The Final Regulations retain these changes, but in response to comments, they also clarify that the cost of a non-creditable tax is one of the costs that taxpayers may take into account in this regard. In Example 7, Country X imposes a 20% generally applicable corporate income tax and a 25% non-creditable base erosion tax. CFC, a Country X corporation, has a choice of claiming certain deductions that would reduce its corporate income tax from 80 to 60, but would also cause it to be liable for 25 of base erosion tax. The example concludes CFC may forgo the deductions, and the entire 80 of corporate income tax is still a compulsory payment.
The Final Regulations include special provisions on foreign anti-hybrid rules, allowing one taxpayer to waive an otherwise allowable deduction if doing so reduces a second taxpayer’s foreign income tax liability by a greater amount by deactivating a hybrid mismatch rule that otherwise would apply.
With respect to exhaustion of remedies, the Final Regulations provide that taxpayers must exhaust all practical and effective remedies, and an available remedy is practical and effective if an economically rational taxpayer would pursue it whether or not a compulsory payment of the amount at issue would be eligible for a foreign tax credit. As under the 1983 Regulations, settlements of multiple issues are evaluated on an overall basis.
These rules generally apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021.
In addition to incorporating the attribution requirement, the Final Regulations under §1.903-1 also impose a more stringent burden of proof on taxpayers to show that a claimed §903 tax is imposed in substitution for a generally imposed income tax. The basic rule of §903 remains the same: The levy at issue must be a tax, and it must meet the substitution requirement. However, the substitution requirement has been expanded into a four-part test, each part of which must be satisfied for a foreign tax to qualify as an in-lieu-of tax under §903.
First, the foreign country must have a generally applicable income tax. Second, the tested foreign tax must be “non-duplicative.” That is, none of the gross receipts in the tax base of the tax can also be included in the tax base of generally applicable income tax. Third, a “close connection” must exist between the two taxes, such that the taxpayer can show that the foreign country made a “deliberate and conscious choice” to impose the tested tax in lieu of the normal income tax. Taxpayers are required to prove this through specific means, for example, by identifying an explicit cross‑reference between the two taxes, or through the foreign legislative history. This flawed and unfortunate new requirement presumably will require opinions of foreign counsel in many cases to establish §903 creditability. It also runs counter to Treasury’s protestations in the preamble about making the rules more administrable for taxpayers and the government. Fourth, the tested tax must satisfy the attribution requirement under §1.901-2.
A simpler test applies for “covered withholding taxes,” given that these are the classic taxes eligible for §903. This test deems a withholding tax to be creditable if it is imposed on nonresidents, it doesn’t duplicate a regular income tax, and it meets the attribution requirement. In most cases, withholding taxes will only meet the attribution requirement under the source test which, as discussed above, requires the foreign law source rule to be “reasonably similar” to the Code source rule for the same type of income.
Section 1.903-1(d), Example 2 illustrates how the attribution requirement applies to an “Electronically Supplied Services” (ESS) excise tax, which appears similar to digital services taxes. The example concludes that the ESS, even if clearly imposed instead of (i.e., “in lieu of”) a traditional nonresident income tax, will fail to be creditable because it will not satisfy the attribution requirement. The ESS is not a covered withholding tax because the foreign country’s source rule is based on market location, rather than where the service is performed.
These rules generally apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021.
The Final Regulations make some small changes and add some examples to the foreign branch basket rules under §1.904-4(f). New rules are added with respect to so-called “non-branch taxable units”—foreign disregarded entities that do not conduct sufficient activities to give rise to a “branch.” The new rules address how disregarded payments are treated when made to or from a non-branch taxable unit. In general, the non-branch unit is treated as a member of a “foreign branch group” or a “foreign branch owner group,” and the disregarded payment rules are applied as if the non-branch taxable unit were a foreign branch or foreign branch owner, as appropriate.
A new example addresses how the foreign branch disregarded payment rules interact with the consolidated return regulations. In §1.904-4(f)(4), Example 15, USP earns 400 of U.S. source royalty income and pays 350 to a foreign branch owned by USS for services that relate to that royalty income. USS is a wholly owned subsidiary of USP and a member of its consolidated group. On a separate entity basis, USS would earn foreign source income. However, the service fee paid to USS’s foreign branch is an intercompany transaction, and under the matching rule of Treas. Reg. §1.1502‑13(c), USS’s income is redetermined to be U.S. source income (i.e., the same result as if USP and USS were a single entity).
These rules apply to taxable years that begin after December 31, 2019, and end on or after November 2, 2020.
The Final Regulations provide a comprehensive set of rules governing when foreign tax credits may be claimed. These rules largely codify longstanding principles, but also make some important changes.
For accrual-basis taxpayers, §1.905-1(d) provides that the credit is allowed in the year in which the foreign taxes accrue, i.e., the year in which all the events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy. (The economic performance rule does not apply in determining the timing of creditable foreign income taxes.) In the case of foreign income taxes, that occurs on the last day of the foreign tax year. Foreign withholding taxes that are advance payments of a foreign net income tax accrue at the close of the foreign taxable year, while foreign withholding taxes imposed on a payment giving rise to an item of foreign gross income accrue on the date of the payment (or the date the payment is treated as made under foreign tax law).
Any additional foreign tax paid, when a foreign tax audit is settled, for example, relates back and is considered to accrue at the end of the relevant foreign tax year (the “relation-back year”). Additional withholding tax paid as a result of a change in foreign income (such as a transfer pricing adjustment) also relates back. However, under §905(c), additional taxes not paid within 24 months of the close of the taxable year to which they relate cannot be claimed as credits until they are actually paid. Once paid, they are allowed as a credit in the relation-back year.
The Final Regulations layer on top of these general timing rules several new rules for the allocation of foreign income taxes in the case of certain mid-year events. Building on earlier regulations, §1.901-2(f)(5) addresses not only changes in the owners of a partnership or disregarded entity, but now also changes in entity classification, that occur in the middle of a foreign tax year. The foreign income taxes for the year must be allocated between the before and after periods under the principles of §1.1502-76(b). In §§1.336-2(g) and 1.338-9(d), the Final Regulations require a similar allocation in the case of a mid-year §336 or §338 election.
For a contested liability, once the contest is resolved and paid, the liability is considered to accrue in the relation-back year and only then can be claimed as a credit in that earlier year, provided the statute of limitations on refund claims has not expired. In a change from prior law, the mere payment of a contested liability will not allow a foreign tax credit to be claimed, unless the taxpayer elects to claim a provisional credit under the procedures in §1.905-1(d)(4). These procedures require the taxpayer to file an amended return claiming the provisional credit on Form 1116 or 1118, together with an agreement not to assert the statute of limitations as a defense before the date that is three years after the later of the filing date or the due date (with extensions) of the return for the taxable year in which the taxpayer notifies the IRS of the resolution of the foreign tax contest. In the interim, the taxpayer also must file an annual notice with its timely-filed return. In response to a comment, the Final Regulations remove the proposed rule that any failure to comply with the annual notice requirements results in a deemed refund of the foreign tax.
In response to another comment, the Final Regulations clarify that if a U.S. taxpayer makes this election with respect to contested taxes of a CFC, the taxpayer can claim the deemed paid credit in the relation-back year, and the CFC can take the deduction for the contested foreign income tax into account in computing its taxable income in the relation-back year.
Section 1.905-1(d)(5) addresses in some detail the correction of improper foreign tax accruals. It provides that a change in the timing of accruing a foreign tax expense, including a change from an improper method, is generally a change in method of accounting and taxpayers must file a Form 3115. An improper method includes accruing taxes in the wrong year, or failing to apply the relation-back doctrine, but does not include corrections to estimated accruals or errors in computing the amount of foreign tax. If a change in method is approved, adjustments are made under a modified cut-off approach. A §481(a) adjustment is neither required nor permitted for foreign income taxes that were improperly accrued (or improperly not accrued) in taxable years before the year of change. In general, no adjustment is required under §905(c) solely by reason of an improper accrual. The Final Regulations provide additional details, as well as several examples illustrating these rules.
These rules generally apply to foreign taxes paid or accrued in taxable years beginning on or after December 28, 2021.
Section 245A(d) generally disallows FTCs for foreign taxes attributable to distributions for which a dividends received deduction is available under §245A.
The Final Regulations modify the proposed regulations, which Treasury acknowledged did not clearly describe the income to which foreign gross income should be treated as corresponding for purposes of allocating and apportioning foreign income taxes under §1.861-20. Section 1.245A(d)-1 provides that no credit or deduction is allowed for foreign income taxes attributable to (1) “§245A(d) income” of a domestic corporation, a successor of a domestic corporation, or a foreign corporation, or (2) “non-inclusion income” of a foreign corporation. Accordingly, the disallowance of a foreign tax credit 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 certain disregarded payments to the extent the foreign income taxes are attributable to §245A(d) income. The disallowance also applies where a foreign corporation pays or accrues foreign income taxes that are attributable to §245A(d) income of the foreign corporation. The taxes are not eligible to be deemed paid taxes under § 960 in any taxable year.
Section 245A(d) income means, in the case of a domestic corporation, dividends or inclusions for which a deduction under §245A(a) is allowed, a distribution of §245A(d) PTEP, and hybrid dividends and inclusions related to tiered hybrid dividends under §245A(e). In the case of a successor of a domestic corporation, §245A(d) income means a distribution of §245A(d) PTEP. In the case of a foreign corporation, §245A(d) income means an item of subpart F income that gives rise to an inclusion for which a deduction under §245A(a) is allowed, a tiered hybrid dividend, and a distribution of §245A(d) PTEP. Non-inclusion income is defined as income items of a foreign corporation other than subpart F income, “gross included tested income” (i.e., gross tested income multiplied by the domestic corporation’s inclusion percentage), or income described in §245(a)(5), without regard to §245(a)(12) (items of income constituting post-1986 undistributed U.S. earnings).
These rules apply retroactively to tax years of a foreign corporation that begin after December 31, 2019, and end on or after November 2, 2020.
The Final Regulations retain the rule in the proposed regulations 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, and 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 then 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 U.S. person) assigned to the groupings under the rules of §1.861-9(g) in the U.S. taxable year in which the disposition occurs.
The Final Regulations also retain the rule in the proposed regulations that 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). Treasury rejected a comment requesting to treat a partnership distribution as made out of a partner’s distributive share of partnership income.
In respect of disregarded payments between taxable units, the Final Regulations, like the proposed regulations, characterize 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. The definitions of the terms “contribution” and “remittance” are adjusted so that, together, they describe all payments that are not reattribution payments.
Foreign gross income arising from a reattribution payment is assigned 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. Foreign gross income arising from a contribution received by a taxable unit is assigned to the residual grouping, and foreign gross income arising from a remittance is assigned 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. Treasury rejected comments 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.
These rules apply retroactively to tax years that begin after December 31, 2019, and end on or after November 2, 2020.
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, and different rules regarding a recipient’s location apply in the case of an electronically supplied service (ESS). The proposed rules modified the ESS definition to clarify that the value of the service must be delivered primarily from the service’s automation and electronic delivery.
The Final Regulations adopt the proposed rules largely without change, defining an ESS as generally a service that is delivered primarily over the internet or an electronic network and for which value of the service to the end user is derived primarily from automation or electronic delivery. An ESS includes the provision of access to digital content, such as streaming content; on-demand network access to computing resources; the provision or support of a business or personal presence on a network, such as a website or a webpage; online intermediation platform services; services automatically generated from a computer via the internet or other network in response to data input by the recipient; and similar services. An ESS does not include services that primarily involve the application of human effort by the renderer, such as legal, accounting, medical or teaching services.
These rules apply retroactively to tax years beginning on or after January 1, 2021.