United States: Final FTC Regulations - A Nexus Rule By Any Other Name Is Not the Same

In brief

On 4 January 2022, Treasury and the IRS published another tranche of final regulations regarding the foreign tax credit. The final rules adopt with some significant changes proposed regulations published on 12 November 2020. One of the most controversial new proposals, a jurisdictional nexus requirement, remains in the final rules, though clarified and called by a different name. While we will publish a detailed alert on the final regulations in the coming weeks, we highlight three sourcing rules of concern.

Key takeaways

  •  Final regulations include new language meant to add clarity and flexibility, but which may result in double taxation of transactions that give rise to foreign taxes that traditionally would have been creditable.
  • The rules, effective for tax years beginning on or after 28 December 2021, create immediate uncertainty for multinational companies.


The United States taxes U.S. persons on their worldwide income. To mitigate double taxation of foreign-source income, the Internal Revenue Code provides that a U.S. person generally is entitled to claim a foreign tax credit (“FTC”) for a levy imposed by a foreign government that is a tax (or in lieu of a tax), imposed on the income of the taxpayer, and paid or accrued by the taxpayer during the tax year.1

Treasury Regulations provide technical guidance for determining when a foreign levy is (or is in lieu of) a foreign income tax for FTC purposes. Under former Reg. §1.901-2, each foreign levy was evaluated on a separate basis and was a foreign income tax if and only if:

  • It was a tax; and
  • The predominant character of that tax was that of an income tax in the U.S. sense.

Until the publication of the proposed regulations in 2020, there was no jurisdictional nexus requirement in the FTC regulations.

2020 Proposed Regulations Introduce Jurisdictional Nexus Requirement

Recently, foreign jurisdictions have been adopting or considering adopting unilateral measures such as digital service taxes (DSTs), which “diverge in significant respects from traditional norms of international taxing jurisdiction as reflected in the Internal Revenue Code.”2 These rules take into account as a significant factor the mere location of customers, users, or any other similar destination-based criterion, or the mere location of persons from whom the nonresident makes purchases in the foreign country (“destination-based taxes”). DSTs and destination-based taxes were perceived as targeting U.S. multinationals, specifically the U.S.-based technology industry.

In response to these unilateral measures, the IRS released proposed regulations3 (the “2020 Proposed Regulations”) on 12 November 2020. The 2020 Proposed Regulations introduced a jurisdictional nexus requirement that would affect the creditability for FTC purposes of DSTs, destination-based taxes, and taxes imposed under Pillar One of the Organisation for Economic Co-operation and Development’s global tax reform.4 The preamble to the 2020 Proposed Regulations stated that:

[The fundamental purpose of the FTCs] is served most appropriately if there is substantial conformity in the principles used to calculate the base of the foreign tax and the base of the U.S. income tax. This conformity extends not just to ascertaining whether the foreign tax base approximates U.S. taxable income determined on the basis of realized gross receipts reduced by allocable expenses, but also to whether there is a sufficient nexus between the income that is subject to tax and the foreign jurisdiction imposing the tax.5

Under the 2020 Proposed Regulations, a foreign tax imposed on a nonresident could meet this jurisdictional nexus requirement in one of three ways: (i) based on activities within the country imposing the tax, (ii) based on income sourced to the country imposing the tax, or (iii) based on income from the sale or disposition of certain property located in the country imposing the tax. Any source of income rules that applied had to be “reasonably similar” to those that apply for U.S. federal income tax purposes. Specifically, the 2020 Proposed Regulations required that income from services must be sourced based on the place of performance of the service, and not the location of the services’ recipient.

Note: As the IRS and Treasury were considering comments on the 2020 Proposed Regulations, the Inclusive Framework, including the United States, finalized their two-pillar global tax framework designed to address the tax challenges of the digital economy on 8 October 2021. Countries responded quickly to address unilateral measures, including DSTs. See the Tax News and Developments article, Historic Global Tax Agreement Reached.6

A number of U.S.-based technology companies advocated for the jurisdictional nexus requirement to be removed from the FTC regulations entirely. They argued that if kept, the nexus requirement would result in double taxation by undermining the principle purpose of the foreign tax credit provisions and narrowing the scope of foreign taxes that have been creditable under the long-standing regulations. Several factors supported their position, including the following:

  • US source rules do not align with traditional international tax norms for source rules regarding the treatment of services and royalties and would often result in a mismatch.
  • US source rules often produce uncertain results when applied (e.g., inconsistent rulings and authorities on the place of use test and different conclusions on character of income), complicating administration of the proposed rules.
  • Application of the nexus requirement would not curb proliferation of unilateral measures, but would only further harm U.S. multinationals affected by these unilateral and destination-based taxes.
  • The jurisdictional nexus rule is inconsistent with Pillar One, and puts global consensus at risk.
  • The jurisdictional nexus rule is outside the scope of Treasury’s rulemaking authority.

Acknowledging some of taxpayers’ concerns with the 2020 Proposed Regulations, Treasury Deputy Assistant Secretary for International Tax Affairs, Jose Murillo, indicated in October 2021 that there would be a bit more flexibility in the final regulations concerning “the requirement that foreign law be reasonably similar to U.S. law.”7

Final FTC Regulations

Treasury and the IRS made significant changes to the jurisdictional nexus requirement in final regulations published on 4 January 2022 (the “Final Regulations”).8 First, the jurisdictional nexus requirement was renamed the “attribution requirement.” Second, it was moved and added as a condition of the net gain requirement of Reg. §1.901-2(b)(5). Treasury and the IRS also attempted to add clarity and flexibility to the “reasonably similar” requirement.

Under the Final Regulations, a foreign levy is a foreign income tax only if it is a foreign tax and either:

  • it is a net income tax as defined in Reg. §1.901-1(a)(3), or
  • it is a tax in lieu of an income tax as defined in Reg. §1.903-1(b).

Note: This rule is superseded where a foreign levy is treated as an income tax under the relief from double taxation article of a U.S. income tax treaty with the foreign country imposing the tax and a U.S. citizen or resident pays the tax and elects benefits under the treaty.9 Unfortunately, this rule does not apply to the payment of a foreign tax paid by a CFC even if covered under a foreign to foreign treaty.10

As with the jurisdictional nexus test in the 2020 Proposed Regulations, the attribution requirement must be met in order for a levy to be creditable as a foreign income tax. The activities-based attribution requirement is generally met for gross income arising from taxpayer activities under reasonable principles (e.g., similar to effectively connected income principle under section 864(c)) but does not include destination-based taxes. The property-based attribution requirement is generally met for sales or dispositions of property located in the foreign country. We focus here on the source-based attribution requirement to highlight three rules of immediate concern.

Sourcing Rules

Under the source-based attribution requirement, gross income (other than gross receipts from sales or other dispositions of property) that arises from gross receipts that is included in the base of the foreign tax on the basis of source “is limited to gross income arising from sources within the foreign country that imposes the tax, and the sourcing rules of the foreign tax law are reasonably similar to the sourcing rules that apply under the Internal Revenue Code.”11 To address taxpayer concerns, Treasury and the IRS added language in the Final Regulations stating that a “foreign tax law’s application need not conform in all respects to the application of those sourcing rules for Federal income tax purposes.”12 Further, the Final Regulations clarify that the character of gross income arising from gross receipts is generally determined under the foreign tax law.13 Accordingly, after the character of income is determined under foreign tax law then the foreign sourcing rule for that category of income is compared to the U.S. sourcing rule to determine whether it is “reasonably similar.”14 In making this determination for certain types of income, however, the Final Regulations impose an additional set of requirements in order for the foreign sourcing rule to qualify as reasonably similar to the U.S. sourcing rule.15

Royalties: Under the Final Regulations, gross income from royalties must be sourced based on the place of use of or the right to use the intangible property.16 As Gary Sprague discusses in the article, Application of Treasury’s New “Reasonably Similar” Source Rule Requirement to Claim Foreign Tax Credits for Royalty Withholding Taxes, this requirement is likely to result in the denial of U.S. FTCs for royalty withholding taxes that traditionally would have been creditable.  Ironically, the trigger for this result is not that the foreign law regime is inconsistent with international norms (under which royalty withholding tax is generally imposed based on the residence of the payor), but rather because the U.S. sourcing rule for royalty income is out of step with the international norms. The article highlights examples from the Final Regulations to illustrate the denial of FTCs even in circumstances where a foreign sourcing rule for royalties based on the residence of the payor yields the same country of source as the U.S. rule that sources royalties based on place of use.17

Services: Under the Final Regulations, gross income from services must be sourced based on where the services are performed as determined under reasonable principles, which do not include determining the place of performance of the services based on the location of the service recipient.18 Again, Treasury and the IRS ignore the rule that is most common globally and in our own tax treaties. The UN model treaty preserves the right of payor states to impose withholding tax on a variety of cross-border payments, and the United States has entered into many treaties, including the U.S.-India treaty, where the foreign government is allowed to exercise its domestic taxing authority over services. Despite these facts and comments requesting reconsideration, the Final Regulations remove Example 3 in former Reg. §1.903-1(b)(3), which provided a foreign withholding tax on fees for technical services performed outside the source state were a creditable tax under section 903.

Copyrighted Articles: Under the Final Regulations, attribution of gross receipts from sales or other dispositions of property are not determined under the source rules, but rather under the rules related to activities or sales of property. Further, in the case of sales of copyrighted articles (under rules similar to Reg. §1.861-18), a foreign tax satisfies the attribution requirement only if the transaction is treated as a sale of tangible property and not as a license of intangible property.19 Because the U.S. characterization of the transaction overrides any license characterization under foreign law, this rule has the potential to deny FTCs for any foreign royalty withholding tax imposed on a transaction that the U.S. would treat as a sale of a copyrighted article.


In the Preamble to the Final Regulations, Treasury argued that the modifications to the source-based nexus requirement would provide “additional flexibility and clarity.” Unfortunately, these changes shift the focal point in the determination of what is a creditable foreign tax, making the determination more rigid in certain cases and denying FTCs for foreign withholding taxes on whole classes of ordinary transactions that traditionally would have been creditable. Rather than focus on whether U.S. and foreign law would come to the same conclusion on which country has jurisdiction to tax the income, the source-based attribution requirement effectively mandates that the foreign taxing jurisdiction apply the same sourcing rule as the United States, regardless of whether the U.S. rule would reach a different result. This is likely to lead to the routine denial of U.S. FTCs for foreign withholding taxes on royalties and services, except where a U.S. recipient of the income claims the benefits of a U.S. income tax treaty.

1 See sections 901 and 903. Even if a credit is allowed, the amount of the credit may be subject to certain limitations, including under section 904.

2 REG–101657–20, 85 Fed. Reg. 72078, 72088 (12 Nov. 2020).

3 Id. at 72,078.

4 See Prop. Reg. §1.901-2(c)(1) and (2).

5 REG–101657–20, 85 Fed. Reg. at 72088. Although prior regulations under section 901 did contain jurisdictional limitations on the definition of an income tax, see § 4.901–2(a)(1)(iii) (1980) (requiring that a foreign tax follow ‘‘reasonable rules regarding source of income, residence, or other bases for taxing jurisdiction’’), the existing regulations do not contain such a rule.

6 As part of its response to unilateral provisions, the Treasury and IRS have been actively engaged in negotiations with other countries, as part of the OECD/G20 Inclusive Framework on BEPS, to explore the possibility of a new international framework for allocating taxing rights. In the preamble to the final regulations, Treasury and the IRS acknowledge that if an agreement is reached that includes the United States, changes to the foreign tax credit system may be required at that time.

7 Andrew Velarde, Final Regs Will Keep FTC Nexus Rule, With Clarifications, 103 TAX NOTES INT'L 1390 (6 Sept. 2021).

8 T.D. 9959, 87 Fed. Reg. 276 (4 Jan. 2022).

9 Reg. §1.901-2(a)(1)(iii).

10 If a foreign withholding tax is imposed on a payment from a foreign corporation to a CFC, and the tax does not satisfy the attribution requirement, it may still satisfy this requirement if the tax is modified by an income tax treaty between the foreign jurisdiction of which the CFC is a resident and the foreign jurisdiction imposing the tax, and the tax as modified satisfies the requirement. T.D. 9959, 87 Fed. Reg. at 289.

11 Reg. §1.901-2(b)(5)(i)(B).

12 Id.

13 Id.

14 If the Internal Revenue Code lacks a sourcing rule for the income as characterized under foreign law, then the Preamble to the Final Regulations suggests that the “foreign law source rule will satisfy the source-based nexus requirement if it is reasonably similar to the U.S. source rule that applies by closest analogy.”

15 Reg. §1.901-2(b)(5)(i)(B).

16 Reg. §1.901-2(b)(5)(i)(B)(2).

17 See Reg. §1.903-1(d)(3) and (4).

18 Reg. §1.901-2(b)(5)(i)(B)(1).

19 See Reg. §1.901-2(b)(5)(i)(B)(3).

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