For almost four decades, the foreign tax credit regulations have established a three-part net gain requirement for determining when a particular foreign levy is an income tax. Now, things have changed. We assembled a panel of knowledgeable tax practitioners in the space to discuss how these changes came about and what opportunities exist for taxpayers to weigh in on future changes. Panelists included Anne Devereaux, of counsel at Gibson, Dunn & Crutcher in the Los Angeles and Washington, D.C., offices (not yet admitted in California); Rocco Femia, member at Miller & Chevalier in Washington, D.C.; and Michael Caballero, a partner and a vice chair of the tax practice group in the Washington, D.C., office of Covington & Burling LLP. Tax Executive’s senior editor, Michael Levin-Epstein, moderated the discussion. For a rundown of technical corrections to the regulations, flip to the following feature on page 32.
Michael Levin-Epstein: Let’s begin our discussion of foreign tax credits by talking about what existed before the changes and what the revisions are all about.
Anne Devereaux: You mentioned that there’s a three-part net gain test and, obviously, there’s now a fourth element to that test that’s gotten a lot of attention. Previously known as the jurisdictional nexus requirement in the proposed regs and now known as the attribution rule in the final regs, I would say it’s to a great degree inspired by the digital levies that some countries have imposed and the OECD’s BEPS [anti-base erosion and profit-shifting] efforts. I think the addition of an explicit attribution requirement in determining whether a foreign tax is creditable for US purposes is a very significant change, although not a surprise. In addition to that, the FTC regs include a lot of other changes, many resulting from the [Tax Cuts and Jobs Act] and others arising from general rethinking of some of the older rules. I think the IRS and Treasury thought that this was an opportunity to make what they saw as necessary changes in other areas, too.
Levin-Epstein: Rocco, is there anything you’d like to add to what Anne described? Do you want to get into some of the other key elements of the change as you see it?
Rocco Femia: Sure. The attribution rule essentially limits foreign tax credits to foreign income taxes that conform closely to US law from a sourcing-of-income perspective. So, under those rules, foreign tax credits are permitted only with respect to income taxes paid to a foreign jurisdiction that has a nexus with the income being taxed that’s consistent with the US sourcing rules. So, if the US would have taxed such income, then a foreign tax credit would be permitted. If the US would not have taxed such income, then a foreign tax credit would not be permitted. There are also changes as you mentioned to the traditional three-part test and in particular with respect to the cost recovery prong. There’s complexity in the changes, but in essence the rules limit foreign tax credits to foreign taxes that look very much like the US income tax. And so, to the extent the US provides deductions or other recovery for costs, the foreign tax also needs to provide similar deductions or recovery for similar costs. And if it does not, it may not be a creditable income tax under the rules.
Michael Caballero: The only thing I would add
is that—at least in my mind—it’s most interesting that what’s gotten all the attention is that first part, the attribution rule and its disallowance of credits for things like digital taxes and other extra-jurisdictional taxes, but as a practical matter, most of the impact actually follows from that second piece that Rocco really focused on: all of the old historical rules, which there was no compelling need to adjust at this moment in time, have really been tightened up significantly, requiring very close conformity with US tax rules, and thus affecting the creditability of a lot of taxes that have historically been creditable for quite some time. And those rules are also very complicated—in the case of digital taxes, they’re just clearly out. There’s not a lot of analysis that has to be done, and they’re often not very significant in their magnitude, at least at this stage. But that second part, these cost recovery and other factual-based tests, are proving extremely challenging for taxpayers to assess if they are still entitled to claim a foreign tax credit.
Levin-Epstein: Let’s follow up on that. Dig down a little deeper and talk about the complications of that particular part. Why is it so complicated? What’s your advice to taxpayers for how to deal with those complications?
Devereaux: I think it’s very difficult. I should note that I was with the IRS and somewhat involved with certain aspects of these regs before they were issued, so on the one hand I know how hard the government worked to strike a balance. On the other hand, as you say, taxpayers are really struggling to deal with many of these requirements. In general, I think the regs attempted to get rid of the need for empirical inquiries as to the details of foreign tax . . . see, for example, PPL Corp. v. Commissioner, 569 US 329 (2013). But as I think these new rules have shown, I think it’s really almost impossible to get rid of that type of inquiry, for example, in the cost recovery area. Another example of the problem is the regs’ requirement that the base of the foreign levy be determined consistent with the arm’s-length principle, imported from the transfer pricing world.
Femia: I would add that the analysis for taxpayers can hinge on whether the foreign tax is imposed by a country that has a tax treaty with the United States versus a country that does not. The US has tax treaties with sixty-plus jurisdictions, including many of our major trading partners in North America, Western Europe, and the Pacific Rim. Those treaties include a relief-from-double-
taxation article that provides a foreign tax credit, subject to the limitations of domestic law, with respect to taxes covered by those treaties. And those treaties are still in force; they cannot be repealed by regulation, and they provide a mechanism for analysis where they do apply that might allow taxpayers and their advisors to shortcut some of these factual analyses that Michael and Anne were alluding to. Outside of the tax treaty network, there’s no way around this. So, for taxpayers that pay significant amounts of tax and have significant operations in Latin America, for example, they have to do the work, and their advisors have to do the work, to analyze the local tax—and really analyze all aspects of the local tax—up against the standard of the Internal Revenue Code and try to determine whether it is close enough in terms of cost recovery and, as Anne mentioned, the arm’s-length standard to qualify as a creditable foreign income tax.
Caballero: The only couple things I’d add to that is one, I agree with Rocco. You’re analyzing foreign law, and every foreign tax system is a very complicated set of rules. So there’s a very significant challenge there. The other thing is, notwithstanding the fact that every country is basically taxing the same amount of income in my experience—because the concept of what net income is is reasonably consistent—every tax code is very idiosyncratic. The Internal Revenue Code isn’t just Section 61 and Section 162. It’s not just income less deductions. Over 100 years, Congress has come up with a number of ways to limit deductions. Just in the case of interest, there are multiple reasons why they’ve enacted the various different limitations in Section 163. And so, taxpayers are forced to try and line up a wide variety of decisions by both our legislature and the legislatures of foreign countries to make sure they are in close enough conformity, whether based on the principles or the policies or even the technical operation of how these rules apply. And that is a very challenging thing if you only had one country to deal with, but of course, many multinationals have twenty, forty, sixty, or more countries where they’re facing this challenge.
The Royalty Issue
Levin-Epstein: Let’s move on to the issue of royalties, which my understanding is that that might be a complicated area as well. The source-based attribution requires that the foreign sourcing rules be “reasonably similar” to US sourcing rules. And in the case of royalties, that character of which is determined under foreign law requires that the foreign law sources the income on the basis of the place of the licensed IP. So, can you help decode that for our members. What exactly does that mean?
Devereaux: One point is that I think that that rule reflects kind of the practical position that the IRS arguably has taken for many years. Obviously, the specific language regarding the sourcing of royalty payments wasn’t in the regs before, but I think that it and several of the other “new” rules are intended to crystalize concepts that have existed for some time. In some ways I think the bottom line is that, because comparing tax systems is a necessary evil in determining the creditability, the rules have never been easy to apply—but we all became somewhat inured to working with the old regs. I do think it’s a complicated area, and again, I believe the regs were heavily informed by similar work that’s happening in the OECD and elsewhere.
Femia: This rule essentially permits a credit for foreign withholding taxes on royalties only where foreign law provides that that withholding tax is imposed based on a US-style place-of-use sourcing rule. A couple of observations. First, many jurisdictions do not have a place-of-use sourcing rule; they have a rule that looks to the residence of the payer, or a multi-factor rule that looks to the residence of the payer, or whether the royalty is paid by a business operating in the jurisdiction and is deductible against the income of the business, or place of use. To the extent the foreign tax credit rule is based on the premise that the US-style place of use sourcing rule represents an international norm, that premise is not the case, and that makes the rule problematic. Second, when the rule was issued, it came with an example that demonstrates the application of the rule in a context where the foreign law sourcing rule is residence for the payer, but the IP is in fact used in the jurisdiction imposing the tax. The example provides—consistent with the regulation—that that foreign tax isn’t creditable. That left a lot of us scratching our heads from a policy perspective. Here you have a tax that is imposed in the same amount as under US sourcing principles, but because of the wording of the foreign law, that tax isn’t creditable under the regulations. In other words, there is double taxation and no relief. In light of this result, withholding taxes on royalties have gotten a lot of attention, and certainly Treasury and the IRS are aware of the issues and—as of the date of this recording—they’ve made public statements saying that they are considering what to do about this and whether to change the approach. There are similar issues regarding withholding taxes on services, which have been imposed for many years without any question as to their creditability.
Caballero: The only observation I would add is that this demonstrates the depth and significance of these rules. The headlines when they came out were largely focused on digital taxes. but adjusting the cost recovery rules and tightening them raises issues for a much wider range of foreign taxes, but even that could be seen as an elaboration on prior rules. But there are aspects of these regulations that are a complete reversal in where the US has been for the past hundred years. Admittedly, it’s framed as this technical debate about how the sourcing roles operate in the context of royalty withholding tax, but as a practical matter, it is undoing the creditability of royalty withholding taxes in places where the United States has granted a credit for decades. And I don’t think there’s been a policy or a technical concern about any of those circumstances. So, you’re really talking about a 180-degrees shift in policy, at least in these contexts, with very significant double taxation concerns.
Levin-Epstein: What’s your advice in terms of someone who’s responsible for strategic planning of the tax department? How can members learn more about what the IRS might and about compliance in terms of planning?
Devereaux: Rocco mentioned the US treaty network, and that’s one point that I think will provide a lot of comfort and help multinationals avoid a lot of concerns for tax planning going forward. And I think that the IRS and Treasury are open to discussion and thoughtful feedback, and comment letters can go a long way. This might be an opportunity for execs and planners to engage in some dialogue with the IRS and Treasury.
Femia: I want to second those comments. There are things that taxpayers can do in terms of restructuring and planning around supply chains and income flows that could mitigate some of the harshest consequences of these rules. But that may be only a Band-Aid. For tax executives, the long-term focus should be on engaging with Treasury and with the IRS. As Anne said, the government has shown an openness to listening and reconsidering some of these rules. That is not going to happen overnight, but engaging through TEI and other trade organizations and even directly can help get the system back to where it should be in terms of relieving double taxation.
Caballero: I don’t have much to add except to second all of that. Thankfully, the government is rethinking some of this, so there is a real opportunity for taxpayers to have additional input. Because the information they need is so vast to allow them a more complete understanding these foreign tax systems, the more information they get, hopefully the more helpful the guidance can become. I do think we’re going to see a real challenge though as taxpayers come to the end of the year. The kind of planning people might like to do historically is really not available in a lot of cases. If you have operations in a country, you can’t terminate them—or at least you can’t terminate them without relatively significant business consequences. And thus companies are going to be facing a lot of challenging decisions in assessing foreign taxes under the new rules as they hit quarter ends and, most importantly, when they file their tax return given how factual these questions are. So, while I think these rules have been a challenge for people to this point, I don’t see that dissipating over the next six to twelve months as people continue to grapple with them. And while relief from Treasury and the IRS will be helpful, I think there will still be a lot of issues that remain on the table and that the taxpayers are going to have to confront over the foreseeable future.