INTRODUCTION

A U.S. taxpayer that is subject to income tax in both the U.S. and a foreign country can reduce the amount of tax payable to the U.S. by claiming a credit for foreign income taxes paid or accrued to one or more foreign countries. The principle is simple: taxpayers should not pay tax twice with regard to the same item of income. The application of the principle is not so easy, requiring a taxpayer to overcome several hurdles, including whether the tax is creditable.

The Internal Revenue Code ("Code") provides a credit for two broad classes of tax. First, Code §901 allows a credit for foreign taxes levied on "income, war profits, or excess profits." This is generally understood as the requirement that the foreign tax be an "income tax." Second, Code §903 allows a credit for foreign taxes levied "in-lieu-of" a tax on such items. An example is a gross income tax imposed on nonresidents in connection with income not attributable to a trade or business in the country, where residents with a trade or business are generally taxed on realized net income.1

A tax is generally creditable under Code §901 if it meets the net gain requirement. The net gain requirement is met if the foreign tax meets three tests:

  • The realization test
  • The gross receipts test
  • The net income test

The realization test broadly requires that the tax be imposed on income when the income is realized.2 The gross receipts test generally requires that the tax be imposed on gross receipts or certain equivalents.3 The net income test requires that the tax be imposed on net income (i.e., after recovery of expenses through deductibility or amortization).4

New regulations were adopted at the end of 2021. This article addresses some of the highlights.

NEW REGULATIONS

The new regulations modify the net gain requirement by requiring closer conformity to U.S. tax law, which is a recurring theme of the new regulations, and add another criterion: the attribution requirement.5 This had been known as the jurisdictional nexus requirement in the proposed regulations but was renamed.

The effect is that some foreign taxes that were previously viewed to be creditable under prior regulations may no longer be creditable under the new regulations. The regulations take particular aim at taxes imposed under destination-based criteria, such as customers' location. An example would be a digital services tax that has become popular outside the U.S.

The components of the requirement differ depending on whether the taxpayer is a resident of the foreign country. Foreign tax paid by nonresidents of the foreign country meets the attribution requirement if there is nexus based on one or more of the following criteria: activities, sourcing rules, or property.

Attribution to Nonresidents

Activities-Based Nexus

Activities-based nexus requires that only gross receipts and costs reasonably attributable to the nonresident's activities in the foreign country are included in the tax base.6 Such activities can include "functions, assets, and risks located in the foreign country." In general, attribution is reasonable if it follows principles similar to those set out in Code §864(c), which sets rules for determining effectively connected income ("E.C.I."). This means that gross receipts cannot be taken into account as part of the tax base if they are sourced based on the location of customers or users, or of people from whom the nonresident makes purchases. This requirement excludes rules that tax a taxpayer based on the activities of another person, including a trade or business or permanent establishment created by another person, unless that other person is an agent for or a flow-through entity owned by the taxpayer. In essence, this follows the holding in Miller v. Commr.,7 a case that held a foreign corporation did not have U.S.-source income or effectively connected income when it was a subcontractor of a U.S. related party having a contract with a U.S. customer and all activities of the foreign corporation were performed outside the U.S.

Source-Based Nexus

Source-based nexus is twofold.8 First, income that is included based on source is limited to income sourced to the foreign country. Second, the foreign country's sourcing rules must be similar to U.S. sourcing rules. In response to criticism, the final regulations require reasonable similarity but not complete conformity to U.S. sourcing rules for foreign persons. Specific rules are provided for three types of income:

  • Income from services must be sourced to the place of performance, which cannot be based on the service recipient's location.
  • Royalties must be sourced to the place of use or right to use the intangible property.
  • Income from sales of property is completely excluded from eligibility for source-based nexus. If a taxpayer wants a foreign tax credit for such income, the foreign tax rule must fit either activities-based or property-based nexus.

Property-Based Nexus

Property-based nexus is the only way to meet the attribution requirement for a foreign tax imposed by a foreign country on nonresidents based on the situs of property, including ownership in a corporation or flow-through entity.9

Property-based nexus requires comparison to two provisions of U.S. tax law. First, with regard to real property, creditable foreign tax is limited to sums raised under rules similar to F.I.R.P.T.A., which imposes U.S. tax on foreigners holding U.S. real property. The second concerns tax incurred through disposition of property other than shares in a corporation, but including interests in a partnership, and based on the situs of property other than real property. Creditable foreign tax is limited to sums attributable to property that forms part of the business property maintained by the nonresident in the foreign country, as determined by rules similar to the E.C.I. rules under U.S. tax law.

Attribution to Residents

Wider latitude is provided for a foreign tax imposed on residents of the foreign country imposing the tax. The foreign tax on all of a resident taxpayer's worldwide income will pass the attribution requirement.10 However, the foreign tax rules must require that income between the resident and affiliated entities (i.e., income subject to transfer pricing rules) be calculated under arm's length principles. As with attribution to nonresidents, the tax cannot take into account destination-based criteria.

Income Tax Treaties

Tax treaties sometimes override domestic law, and the final regulations, to an extent, provide for that. If the article on relief from double taxation in a tax treaty between the U.S. and the foreign country treats a foreign tax as an income tax, that tax will be considered an income tax. However, such relief is limited to U.S. residents. A more limited form of relief is available to C.F.C.'s.

APPLICATION

Mr. A is a U.S. person who, through two tiers of flow-through entities, owns and operates a resort in Spain. He does not reside there. The resort is owned directly by a Spanish flow-through entity, which is owned by a Danish flow-through entity. Mr. A decides to sell the resort by selling all of his interests in the Danish entity. The transaction results in the imposition of Spanish capital gains tax at 19%, the rate for nonresidents, based on the underlying real property being located in Spain. There is no Danish tax liability.

Footnotes

1 See the I.R.S. website.

2 Treas. Reg. §1.901-2(b)(2)(i).

3 Treas. Reg. §1.901-2(b)(3).

4 Treas. Reg. §1.901-2(b)(4)(i).

5 T.D. 9959.

6 Treas. Reg. §1.901-2(b)(5)(i)(A).

7 T.C. Memo 1997-134, aff'd without pub. op., 166 F3d 1218 (9th Cir. 1998).

8 Treas. Reg. §1.901-2(b)(5)(i)(B).

9 Treas. Reg. §1.901-2(b)(5)(i)(C).

10 Treas. Reg. §1.901-2(b)(5)(ii).

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.