Technical Corrections to the 2021 Final Foreign Tax Credit Regulations

As readers are well aware, almost a year ago, on December 28, 2021, the Treasury Department issued final foreign tax credit regulations (hereafter the “final regulations”)¹ finalizing the proposed regulations that Treasury had issued the prior year.² On July 26, 2022, Treasury issued two sets of technical corrections to the final regulations.³ These technical corrections offer much-needed clarifications on several critical issues commentators have raised, yet still leave a number of other issues open for future guidance or, potentially, unresolved and for taxpayers and their advisors to muddle through. In this article, we provide a brief recap of the developments to date, an analysis of some of the key fixes in the technical corrections, and some reflections on next steps.

How Did We Get Here?

Taxpayers and the tax practitioner community were surprised—to put it mildly—by the final regulations. Among other adverse changes in the proposed regulations, what most animated taxpayers was the new “attribution” requirement. Treasury had clearly telegraphed in the proposed regulations its view that the ever-increasing number of novel foreign taxes such as digital services taxes (DSTs) that intended to capture elusive digital revenue would not be creditable under the new “jurisdictional nexus” rule. Even so, with regard to tax imposed on nonresident taxpayers on the basis of income arising within a given country, the proposed regulations provided simply that the sourcing rules of the foreign law had to be “reasonably similar to” the rules under US law. And, with the narrow focus of the proposed regulations on DSTs, Treasury prescribed a specific rule only for services income, whereby the income must be sourced according to the place of performance of the services, not the location of the services’ recipient. The final regulations made only minimal changes in response to comments, but replaced the framework in the proposed regulations with a significantly more expansive attribution requirement that would appear to deny a foreign tax credit for many garden-variety taxes, such as royalty withholding taxes. Thus, effectively overnight, the final regulations threw projected global effective tax rate calculations into turmoil as foreign taxes that had been routinely creditable without controversy for decades no longer were. Many other foreign taxes would need to be reexamined and could be considered creditable only upon the advice of tax attorneys and accountants, in conjunction with analysis by foreign counsel.

The one aspect of the final regulations that was no surprise, however, was the response of tax practitioners, reminiscent of the furor following the similarly overbroad Section 385 regulations. Generally, commentators focused on three problematic aspects of the final regulations:

the attribution requirement as applied to withholding taxes imposed on nonresidents;
the attribution requirement as applied to taxes imposed on residents, including the requirement that such tax be determined through arm’s-length principles; and
the revised cost recovery requirement.

For almost forty years, the foreign tax credit regulations have set forth a three-part “net gain” requirement for determining when a particular foreign levy is an income tax: 1) the realization requirement, 2) the gross receipts requirement, and 3) the cost recovery requirement.⁴ The attribution requirement is a new, fourth prong to this preexisting framework. Its underlying purpose is to limit the foreign tax credit to taxes that conform with US tax “nexus” principles (thereby excluding taxes such as DSTs that are imposed without such nexus).⁵ The attribution requirement applies differently to taxes imposed on nonresidents and on residents.⁶ With respect to nonresidents, the taxpayer must establish nexus (or attribution) through one of several ways, including through activities-based attribution (for example, having business profits attributable to a permanent establishment in the country) or source-based attribution (for instance, income arising in the country under a sourcing rule) or attribution based on the property location. Source-based attribution requires that foreign sourcing rules be “reasonably similar” to US sourcing rules and, in the case of royalties (the character of which is determined under foreign law), requires that the foreign law sources the income according to where the licensed intellectual property (IP) is used.⁷ Commentators have noted the difficulty of satisfying this new requirement, especially in the context of many withholding taxes on royalties, since foreign tax law systems routinely do not focus on the “source” of income and almost universally do not impose royalty withholding tax based on the uniquely US principle of where the licensed IP is “used.” With respect to residents, the attribution requirement is satisfied if the tax base of the resident is determined under arm’s-length principles, without considering as a significant factor any destination-based criteria, such as customer locations.⁸ Commentators have pointed out that this limitation would mean that foreign tax credits would no longer be available even for ordinary corporate income taxes imposed by countries such as Brazil that do not follow the arm’s-length principle.

The final regulations also revised the cost recovery requirement, presumably in response to the Internal Revenue Service’s repeated losses in various cases where taxpayers were able to empirically establish that foreign law permitted recovery of significant costs and expenses.⁹ The cost recovery requirement is generally satisfied only if the foreign tax law permits the taxpayer to recover an enumerated list of “significant costs and expenses”: capital expenditures, payments for wages and services, and expenses for interest, rent, royalties, and research and development.¹⁰ Under the final regulations prior to further revision by the technical corrections, a foreign tax law that disallows deductions of some costs and expenses may still be considered to permit recovery of significant costs and expenses if that disallowance is consistent with US principles, such as disallowances under Section 163(j) or Section 267A of the Internal Revenue Code, or if the disallowance is consistent with the principles underlying the Code’s disallowances, including those “intended” to limit base erosion or profit shifting.¹¹ Commentators questioned whether the specific references to Code provisions suggested that any foreign law disallowance must have a comparable US tax provision to satisfy the cost recovery requirement. They also complained that it is often impossible to glean legislative intent for a foreign tax statute given the paucity of foreign legislative history. Commentators were particularly concerned that a credit would be disallowed for a foreign tax if, for example, the foreign country disallowed recovery of expenditures for goodwill (a capital expenditure), stock-based compensation expenses (payment for services), or royalty expenses. Such an interpretation of the rule would have a “cliff effect” whereby the credit is entirely denied if the local country disallows some expenses deemed “significant” under the regulations. Before the technical corrections’ changes to the cost recovery requirement, taxpayers had been concerned that this interpretation might cause certain mainstream foreign taxes to fail the cost recovery requirement, among them the Dutch corporate income tax, which disallows deductions for stock-based compensation paid to employees, and the German trade tax, which limits deductions for royalties, rents, and interest.

Before Treasury issued the technical corrections in July 2022, many commentators requested that, at minimum, Treasury delay the effective date of the final regulations by at least a year to mitigate the expected financial reporting challenges and otherwise allow taxpayers time to fully assess the impact of the final regulations.¹² Treasury denied the request but acknowledged that any changes in the final regulations could be applied retroactively.¹³ At least one sympathetic IRS official, however, explained that as the IRS gathered information it was learning of new issues that were not raised during the comment period for the proposed regulations. Although the IRS remained adamant about its no-rule policy for specific foreign tax credit questions, it envisioned issuing some type of non-precedential guidance, such as chief counsel advice.¹⁴ Subsequently, a Treasury official announced that the agency considered issuing guidance that would provide a “safe harbor” for certain royalty withholding taxes while still maintaining the general attribution rule. The anticipated timing for such guidance would be later in 2022, with the possibility that Treasury would issue it as a regulation to provide certainty to taxpayers, unlike other types of guidance that could be issued faster but might lack reliability or the value of precedent. Treasury further indicated that it intended to provide a “clarification” of the cost recovery requirement to show its intent for the rule to be “principle-based.” Such a clarification would not require a new regulation, but instead could be handled through a “technical correction” to the final regulations. Treasury also hinted at additional guidance on disregarded distributions.¹⁵

True to its word, Treasury issued the technical corrections approximately seven months after the publication of the final regulations. Although the second set of corrections addressed non-substantive drafting issues, the first set addressed several substantive issues, including some of those detailed in the previous paragraph. We discuss some of the more important changes below.

Key Technical Corrections

The technical corrections made three noteworthy changes to the final regulations: 1) in the cost recovery requirement, 2) in the rules for disregarded sales of property, and 3) in the treaty coordination rule.

Cost Recovery Requirement

As Treasury stated publicly before issuing the technical corrections, to allay concerns about a one-to-one correspondence between foreign law and US law, it would simply generalize the language of the cost recovery requirement. A foreign tax law disallowance must now only be “consistent” with “any principle” underlying the disallowances required under the Code, including to limit base erosion or profit shifting (whereas the final regulations used the phrase “the principles”). The technical corrections also made it unnecessary to establish that the foreign country intended the disallowances to limit base erosion or profit shifting; now it is sufficient that the effect of the disallowances is to limit base erosion or profit shifting. The specific references to Sections 163(j) and 267A were removed and replaced with general limitations on deductions for interest and deductions in connection with hybrid transactions, respectively, while retaining the specific reference to Section 162. Treasury also emphasized that the applicable principles include not only those that limit “base erosion or profit shifting” but also “public policy concerns” (albeit still public policy concerns underlying the Code’s disallowances).¹⁶ While it is still not entirely clear what a taxpayer must establish to show that a foreign tax satisfies the cost recovery requirement, the expansive nature of the phrase “public policy concerns” gives taxpayers an easier path to argue that a foreign tax meets the requirement.

Disregarded Sales of Property

The technical corrections made two amendments to Treasury Regulations Section 1.861-20. The first provides that the reattribution rules under Treasury Regulations Section 1.861-20(d)(3)(v)(B) apply to disregarded payments for property. The second, correlative amendment accordingly provides that no portion of a disregarded payment for property is a “remittance” or “contribution.” This second amendment make sense, since Treasury Regulations Section 1.861-20(d)(3)(v)(D) implies that either a disregarded payment for property is a reattribution payment or the item of foreign gross income is characterized under Treasury Regulations Section 1.861-20(d)(2), that is, there does not appear to be room to argue that any element of the transaction is a remittance or a contribution. Generally, Treasury Regulations Section 1.861-20 assigns items of foreign gross income to statutory or residual groupings for purposes of allocating and apportioning a foreign tax by assigning each item of foreign gross income to the grouping to which the “corresponding US item” is assigned. The corresponding US item is the item of gross income under US law that arises from the same event that gave rise to the item of foreign gross income. If there is no corresponding US item because, for example, the event giving rise to the foreign gross income was a nonrecognition transaction or was a disregarded sale of property for US tax purposes, the general rule is to hypothesize that the event did give rise to US gross income, by treating the nonrecognition transaction as a recognition transaction or the sale as regarded, as the case may be. If there is no corresponding US item in a transaction that involves one or more disregarded payments, Treasury Regulations Section 1.861-20(d)(3)(v)(B) provides specific rules for reattributing US gross income to the recipient of the disregarded payment and assigns the item of foreign gross income arising from the disregarded payment to the grouping to which the US gross income was initially assigned.¹⁷ To identify the reattributed US gross income, the rules look to the US gross income of the payer to which the disregarded payment is allocable. If the disregarded payment is allocable to income of the payer that is also disregarded, the rules generally would look to the ultimate payer in the chain that has US gross income. For example, if a disregarded payment of a royalty is allocable to regarded sales income of the payer, the disregarded payment is assigned to the grouping to which the sales income is assigned. Prior to the technical corrections, the rules under Treasury Regulations Section 1.861-20(d) strongly indicated that the disregarded payment rules did not apply to disregarded payments for property, and that the general rule of hypothesizing a regarded sale applied.

The following example illustrates the effect of the technical corrections. Suppose that a controlled foreign corporation (CFC) manufactures a product in a high-tax jurisdiction and sells the product to customers through a branch in a low-tax jurisdiction. The branch makes a disregarded payment to its CFC owner for the products. Further suppose that the CFC’s profits attributable to the branch’s sales are foreign base company sales income. If the reattribution rules did not apply, foreign income tax imposed on the disregarded payment would be allocated to the CFC’s tested income, because the CFC would have tested income if it sold the products to the branch in a hypothetical regarded sale. In that case, the foreign income tax would be allocated to the US shareholder’s global intangible low-taxed income (GILTI) basket. In contrast, if the reattribution rules apply, they appear to allocate and apportion some of the foreign income tax imposed on the disregarded payment to foreign base company sales income because the character of the disregarded payment appears to be determined by the character of the income recognized for US tax purposes on the sale of the products to customers.¹⁸ As a consequence, part of the foreign income tax imposed on the disregarded payment would be allocated to the US shareholder’s general basket.

Treaty Coordination Rule

The final regulations included a treaty coordination rule intended to alleviate some of the anticipated loss of credits under domestic law as a result of the new attribution requirement.¹⁹ Under the rule, a foreign tax that does not meet, for example, the “net gain” requirement can still nevertheless be creditable if 1) the tax is paid by a US resident and 2) it qualifies for relief under an income tax treaty between the United States and the jurisdiction imposing the tax (and the taxpayer elects benefits under that treaty). In other words, an applicable favorable treaty can have the effect of treating a foreign tax as creditable even if that tax might not have otherwise qualified as creditable under the final regulations. If the payer is not a US resident and is instead a CFC, then a less favorable rule applies whereby the tax, if modified by the treaty, is evaluated under the “net gain” requirement as modified by the treaty even if the original, unmodified tax did not satisfy the requirement. For example, if the foreign tax law did not provide that royalties are sourced by reference to where the IP is used, but the applicable treaty did provide for such a sourcing rule, then a royalty withholding tax that would not otherwise be creditable could qualify under the CFC treaty coordination rule. Commentators have pointed out that in practical terms few instances may produce such a fortunate result and therefore the relief provided by the treaty coordination rule for CFCs appears minimal.

Although commentators had hoped that Treasury would expand the application of the treaty coordination rule for CFCs, Treasury made only modest clarifications. The technical corrections did slightly broaden the CFC rule such that the analysis of a treaty-modified tax now applies to all taxes including those paid by a CFC.

Applicability Dates

Effective on publication, the technical corrections generally reference the corrected provisions for their applicability dates. Thus, corrections to Treasury Regulations Section 1.901-2 are generally applicable to foreign taxes paid in taxable years beginning on or after December 28, 2021,²⁰ whereas corrections to Treasury Regulations Section 1.861-20 are generally applicable to taxable years that begin after December 31, 2019, and end on or after November 2, 2020.²¹

Where Do We Go From Here?

With the technical corrections, taxpayers received some moderately helpful and welcome clarifications to the final regulations. Treasury seemed to believe that it was limited in what changes it could make through this type of regulatory update.²² Even more limiting though was Treasury’s continuing commitment to its conceptual approach in the final regulations and rejection of many of the comments received after the issuance of the proposed regulations and then again after the final regulations. To add insult to injury, the new alternative minimum tax on book income, plus its AMT foreign tax credit, is now another area where creditability of foreign taxes is not only a primary concern for taxpayers but also a policy choice for Treasury. In any case, taxpayers are eagerly anticipating the announced safe harbor for royalty withholding taxes, which Treasury has described as providing “a lot of relief.”²³ Although commentators have some concern that a safe harbor may not capture the various fact patterns that taxpayers are discovering as they survey the foreign tax laws on royalty withholding taxes, even a rule that applies to the most common situations would be a substantial improvement. Frankly, compared to the new status quo of no credits at all for many such taxes, taxpayers would accept even marginal relief with open arms.

The larger, lurking question is the impact of new taxes to be imposed under Pillar One and Pillar Two of the second phase of the Organisation for Economic Co-operation and Development’s BEPS program. Absent a US legislative response or new guidance from Treasury, it would seem likely that these new regimes would unleash even more non-creditable taxes. With the control of Congress uncertain after the upcoming midterm elections, a legislative solution may not be in the cards. This may leave any future creditability of such taxes in the hands of Treasury.

Erik Christenson and Daniel Stern are partners and Young-Eun Choi is a senior associate at Baker & McKenzie LLP.

Endnotes

Internal Revenue Service, Treasury Department, “Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income,” 87 Federal Register 276, January 4, 2022.
Internal Revenue Service, Treasury Department, “Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income,” 85 Federal Register 72,078, November 12, 2020.
Internal Revenue Service, Treasury Department, “Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income; Correction,” 87 Federal Register 45,018, July 27, 2022; and Internal Revenue Service, Treasury Department, “Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income; Correction,” 87 Federal Register 45,021, July 27, 2022.
Treasury Regulations Section 1.901-2(b).
Internal Revenue Service, Treasury Department, “Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income,” 87 Federal Register 276, January 4, 2022, at 285 (“[The fundamental purpose of the foreign tax credit] 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 US income tax. This conformity extends not just to ascertaining whether the foreign tax base approximates US taxable income determined on the basis of realized gross receipts reduced by allocable 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”).
Treasury Regulations Section 1.901-2(b)(5).
Treasury Regulations Section 1.901-2(b)(5)(i)(B); Treasury Regulations Section 1.903-1(c)(2)(iii).
Treasury Regulations Section 1.901-2(b)(5)(ii).
See, for example, Exxon Corp. v. Commissioner, 113 T.C. 338 (1999). Treasury explained the change as follows in the preamble to the proposed regulations: “[T]he Treasury Department and the IRS have determined that the empirical standards . . . in the existing regulations create substantial compliance and administrative burdens for taxpayers and the IRS when evaluating whether a foreign tax is an income tax in the U.S. sense” (emphasis added).
Treasury Regulations Section 1.901-2(b)(4)(i)(C).
Treasury Regulations Section 1.901-2(b)(4)(i)(C).
Even certain members of Congress made a similar request. “Lawmakers Ask Treasury to Delay Implementation of Final FTC Regs,” Tax Notes Today, April 29, 2022.
Doug Sword, “Yellen Nixes Foreign Tax Credit Reg Delays, Defends OECD Talks,” Tax Notes Today, June 8, 2022.
Andrew Velarde, “IRS Unrelenting on FTC’s Place on No Rule List,” Tax Notes Today, March 17, 2022.
Andrew Velarde, “Treasury Likely to Issue FTC Regs’ Royalty Withholding Carveout,” Tax Notes Today (March 17, 2022).
Treasury also deleted the “significant” adjective when referencing “capital expenditures”: “the base of the tax is computed by reducing gross receipts . . . to permit recovery of the significant costs and expenses (including capital expenditures).” See Treasury Regulations Section 1.901-2(b)(4)(i)(A). It is unclear whether Treasury was simply fixing a typographical error or if it was intended to reflect a substantive revision, that is, that any capital expenditure must be recovered, not just significant ones.
The reattribution rules also have a quantitative aspect, whereby a specified portion of a disregarded payment is treated as a “reattribution payment.” The amount of the reattribution payment affects whether any remaining portion of the disregarded payment is a remittance or a contribution and could also affect the allocation of a foreign tax imposed on a remittance that the payee makes.
We omit details regarding how the foreign tax is apportioned between tested income and subpart F income.
Treasury Regulations Section 1.901-2(a)(1)(iii).
Treasury Regulations Section 1.901-2(h).
Treasury Regulations Section 1.861-20(i).
Internal Revenue Service, Treasury Department, “Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income; Correction,” 87 Federal Register 45,018, July 27, 2022. (“As published on January 4, 2022 (87 FR 276), the final regulations (TD 9959) contain errors that need to be corrected”) (emphasis added).
Michael Rapoport, “Treasury Tries to Calm Fears Over Foreign Tax Credit Rules,” Bloomberg Tax, July 26, 2022.

Technical Corrections to the 2021 Final Foreign Tax Credit Regulations
Correcting the uncorrectable?