Foreign Tax Credit Regulations: Nexus As The New Credo

• Published date: 01 June 2022
• Subject Matter: Tax, Tax Treaties, Income Tax, Capital Gains Tax
• Law Firm: Ruchelman PLLC
• Author: Wooyoung Lee

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...