Final foreign tax credit regulations issued
The U.S. Department of the Treasury and the Internal Revenue Service released final regulations on the foreign tax credit (FTC) for publication in the Federal Register on 28 December 2021. While the 2021 FTC regulations generally follow the proposed FTC regulations released on 29 September 2020, the new guidance makes several changes to the proposed regulations. (For prior coverage, see BDO’s alert on the proposed regulations).
Additional final FTC regulations on other related subjects, such as the definition of financial services income and entity, the election to capitalize certain expenses in determining the tax book value of assets and the rules requiring the direct allocation of interest expense incurred by certain foreign banking branches have yet to be released.
The following provides a summary of some key takeaways from the 2021 final regulations.
Disallowance of FTC or deduction for foreign income taxes under IRC section 245a(d)
The 2021 final regulations deny an FTC or deduction for foreign income taxes attributable to Internal Revenue Code (IRC) “section 245A(d) income” of a domestic corporation (including a successor) or a foreign corporation, as well as “non-inclusion income” of a foreign corporation. Additionally, consistent with comments received regarding the lack of clarity in the 2020 proposed regulations, the 2021 final regulations removed references to “specified distributions” and “specified earnings and profits.”
“Section 245A(d) income” is defined in the 2021 final regulations as follows:
- For a domestic corporation, dividends or inclusions for which a deduction under IRC Section 245A(a) is allowed, a distribution of section 245A(d) previously taxed E&P (PTEP), and hybrid dividends and inclusions related to tiered hybrid dividends under section 245A(e);
- For a successor of a domestic corporation, a distribution of section 245A(d) PTEP; and
- For a foreign corporation, an item of subpart F income that gives rise to an inclusion for which a deduction under IRC section 245A(a) is allowed, a tiered hybrid dividend and a distribution of section 245A(d) PTEP.
Additionally, “non-inclusion income” of a foreign corporation is defined as income other than subpart F income, tested income or items of income constituting post-1986 undistributed U.S. earnings.
Section 250 foreign-derived intangible income (FDII)
In determining whether a service is an “electronically supplied service,” the 2021 final regulations state Treasury’s intent that services accessed by an end user outside of real time (asynchronously) will not constitute an “electronically supplied service” if, under all the facts and circumstances, the services primarily involve human effort. As a result, the 2021 final regulations remove the reference to “and synchronously” as clarification that the definition depends on the level of human effort rather than being rendered synchronously or asynchronously.
Allocation and apportionment of expenses under section 861 regulations
The 2021 final regulations follow the 2020 proposed regulations for allocating and apportioning foreign income taxes on the following:
- Disregarded payments made between “taxable units”;
- Dispositions of stock and partnership interests; and
- Distributions by partnerships.
Consequently, under the 2020 proposed regulations, tax book value of assets will continue to be used for characterizing foreign gross income pursuant to a remittance, with some definitional changes.
The 2021 final regulations also incorporate the tested unit rules as part of the global intangible low-taxed income (GILTI) high-tax exclusion in lieu of the subpart F high-tax exception regulations (with conforming changes made to the GILTI high-tax exclusion regulations).
Moreover, the Treasury rejected comments requesting a delay in applicability dates; therefore, these rules apply to tax years beginning after 31 December 2019 and ending on or after 2 November 2020.
Creditability of foreign taxes under sections 901 and 903
The 2020 proposed regulations introduced a “jurisdictional nexus” requirement for determining whether a foreign tax qualifies as a foreign income tax for purposes of sections 901 and 903 (“in-lieu-of” tax). As part of the 2021 final regulations, “jurisdictional nexus” was replaced with a new “attribution requirement” and incorporated into the existing net gain requirement to reflect that the rule limits the scope of gross receipts and costs attributable to a taxpayer’s activities and, thus, is appropriately included in the foreign tax base for other net gain requirement purposes. Under the “attribution requirement,” a foreign tax under sections 901 and 903 generally will not be creditable unless the foreign tax law requires sufficient nexus between the country and the taxpayer’s activities, and the “attribution requirement” continues to include activities-based, source-based and situs-based nexus rules. When foreign law and U.S. law characterize gross income or gross receipts differently, foreign law characterization will generally govern.
Treasury also provided clarification in the 2021 final regulations regarding the close connection test, as well as the jurisdiction-to-tax test, as part of the substitution requirement for an “in-lieu-of” tax.
FTC timing rules
The 2021 final regulations confirm that foreign net income taxes accrue at the end of the foreign taxable year and can be claimed as a credit by an accrual basis taxpayer only in the U.S. taxable year with or within which the taxpayer’s foreign taxable year ends. Additionally, a section 905(a) election for a cash-method taxpayer to claim FTCs on the accrual basis is a one-time, irrevocable election that must be made on a timely filed original Form 1116 or Form 1118. The section 905(a) election can be made on an amended return only by a taxpayer that has never claimed an FTC.
The 2021 final regulations also address elections to claim provisional FTCs for contested taxes, as well as timing issues for pass-through entities and the approach for correcting improper accruals.