Foreign Tax Credit Regulations: Nexus as a New Creed – Capital Gains Tax
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A U.S. taxpayer who is subject to income tax in the United States and in a foreign country may reduce the amount of U.S. tax payable by claiming a credit for foreign income taxes paid or owing. to one or more foreign countries. The principle is simple: taxpayers do not have to pay tax twice on the same item of income. The application of the principle is not so easy, requiring a taxpayer to overcome several obstacles, in particular that of knowing if the tax is creditable.
The Internal Revenue Code (“Code”) provides a credit for two major categories of taxes. 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 these items. An example is a gross income tax imposed on non-residents in respect of income not attributable to a trade or business in the country, where residents with a trade or business are generally taxed on the net income earned.1
A tax is generally creditable under Code §901 if it satisfies the net gain requirement. The net gain requirement is satisfied if the foreign tax meets three criteria:
- The achievement test
- The gross revenue test
- The Net Income Test
The achievement test generally requires that tax be imposed on the income when the income is realized.2 The gross receipts test generally requires that the tax be imposed on gross receipts or some equivalent.3 The net income test requires that tax be imposed on net income (ie after recovering expenses through deductibility or depreciation).4
New regulations were passed at the end of 2021. This article discusses some of the highlights.
The new regulations modify the net gain requirement by requiring greater compliance with US tax law, a recurring theme of the new regulations, and add another criterion: the attribution requirement.5 This requirement was known as the jurisdictional connection requirement in the draft regulations, but has been renamed.
The effect is that certain foreign taxes that were previously considered creditable under earlier regulations may no longer be creditable under the new regulations. The regulations specifically target taxes imposed on destination-based criteria, such as the location of customers. An example would be a digital services tax that has become popular outside of the United States.
The elements of the requirement differ depending on whether or not the taxpayer is a resident of the foreign country. Foreign tax paid by non-residents of the foreign country satisfies the attribution requirement if there is a connection based on one or more of the following criteria: activities, supply rules or ownership.
Allocation to non-residents
The activity-based nexus requires that only gross income and costs reasonably attributable to the nonresident’s activities in the foreign country be included in the tax base.6These activities may include “functions, assets and risks located in the foreign country”. In general, attribution is reasonable if it follows principles similar to those set forth in Code §864(c), which establishes rules for determining effectively tied income (“ECI”). This means that gross receipts cannot be taken into account in the tax base if they come from the location of customers or users, or persons from whom the non-resident makes purchases. This requirement excludes rules that tax a taxpayer based on the activities of another person, including a trade, business or permanent establishment established by another person, unless that other person is an agent or a flow-through entity. owned by the taxpayer. Essentially, this follows the decision of Miller v. Comr.,sevena case where a foreign company had no U.S.-source income or effectively tied income when it was a subcontractor of a U.S.-related party with a contract with a U.S. customer and that all of the foreign company’s business was conducted outside of the United States
The link based on the source is double.8 First, the income that is included based on source is limited to income from the foreign country. Second, the foreign country’s procurement rules must be similar to the US procurement rules. In response to criticism, the final regulations require reasonable similarity but not full compliance with US foreign sourcing rules. Specific rules are provided for three types of income:
- Revenue from services must originate from the place of performance, which cannot be based on the location of the recipient of the service.
- Royalties must arise from the place of use or the right to use the intangible.
- Income from the sale of goods is completely excluded from eligibility for source-based linkage. If a taxpayer wants a foreign tax credit for such income, the foreign tax rule must match the activity-based or property-based nexus.
Ownership nexus is the only way to satisfy the requirement to attribute foreign tax imposed by a foreign country to nonresidents based on the situs of property, including ownership of a corporation or of an intermediate entity.9
The ownership nexus requires comparison with two provisions of US tax law. First, with respect to real estate, deductible foreign tax is limited to amounts collected under rules similar to FIRPTA, which imposes US tax on foreigners who own US real estate. The second concerns the tax resulting from the alienation of property other than shares in a company, but including interests in a partnership, and based on the situs of property other than immovable property. Foreign tax creditable is limited to amounts attributable to property that is part of the business property maintained by the nonresident in the foreign country, as determined by rules similar to the ECI rules under US tax law.
Allocation to residents
Greater latitude is provided for a foreign tax imposed on residents of the foreign country imposing the tax. Foreign tax on all worldwide income of a resident taxpayer will satisfy the attribution requirement.ten However, foreign tax rules must require that income between the resident and affiliated entities (i.e. income subject to transfer pricing rules) be calculated according to arm’s length principles. As with the allocation to non-residents, the tax cannot take into account criteria based on destination.
Tax treaties sometimes override national law, and final regulations, to some extent, provide for this. If the double tax relief article in a tax treaty between the United States and the foreign country treats a foreign tax as an income tax, that tax will be treated as an income tax. However, such relief is limited to US residents. A more limited form of relief is available for CFCs.
Mr. A is a US person who, through two levels of pass-through entities, owns and operates a resort in Spain. He doesn’t live there. The complex is directly owned by a Spanish intermediate entity, itself owned by a Danish intermediate entity. Mr. A decides to sell the complex by selling all of his interests in the Danish entity. The transaction results in the imposition of a Spanish capital gains tax of 19%, the rate applicable to non-residents, based on the fact that the underlying property is located in Spain. There is no Danish tax liability.
1 See IRS website.
2 treasures. Reg. §1.901-2(b)(2)(i).
3 treasures. Reg. §1.901-2(b)(3).
4 treasures. Reg. §1.901-2(b)(4)(i).
6 Treasures. Reg. §1.901-2(b)(5)(i)(A).
7 TC Memo 1997-134, confirmed without publication. op., 166 F3d 1218 (9th Cir. 1998).
8 treasures. Reg. §1.901-2(b)(5)(i)(B).
9 Treasures. Reg. §1.901-2(b)(5)(i)(C).
10 treasures. Reg. §1.901-2(b)(5)(ii).
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