In more detail

Corrections to reattribution payment rules

Prior to the Technical Corrections, the reattribution payment rules did not apply to a disregarded payment received in exchange for property. The regulations had provided that the rules of Treas. Reg. section 1.861-20(d)(2) governed disregarded payments received in exchange for property. Treas. Reg. section 1.861-20(d)(2), in turn, provides that foreign law gain that is subject to foreign tax upon an event that is a disposition of property under foreign law but not a disposition of property under US federal income tax law is assigned to the grouping to which a corresponding US item of gain or loss would be assigned on a taxable disposition of the property under US federal income tax law, without mentioning the reattribution payment rules. The corresponding US item of gain or loss on a taxable disposition of property under US federal income tax law would be the item of US gross income or loss that would have arisen from the disposition, had there been a disposition for US federal tax purposes. It is difficult to believe that Treasury contemplated all along that applying the reattribution payment rules was part of the process of hypothesizing the taxable disposition of the property under US federal income tax law under paragraph (d)(3)(v)(D) and (d)(2), especially since, under the revised regulations, such hypothetical disposition only applies to the extent that the disregarded sale is not treated as a reattribution payment.

The corrections to Treas. Reg. section 1.861-20 provide that the pre-correction rules only apply to the portion of the disregarded payment “other than the portion of the disregarded payment that is a reattribution payment.” In other words, first the reattribution payment rules apply to disregarded sale of property and then only the amount, if any not treated as a reattribution payment, is subject to the rule that applied prior to the Technical Corrections.

Applying the reattribution payment rules to a disregarded payment of property could have the effect of allocating a foreign tax imposed on a disregarded payment from, say, the tested income group to the foreign base company sales income group. Consider a scenario where a CFC manufactures products through a manufacturing branch in country M which it sells to a low-taxed sales branch of the CFC in country S. The sales branch makes a disregarded payment to the manufacturing branch for the products, and sells the products to third-party customers. The CFC’s profits are attributable in part to the sales branch’s activities and in part to the manufacturing branch’s activities. Suppose that the CFC’s profits attributable to the sales branch are foreign branch company sales income and those attributable to its manufacturing are tested income. One might expect that the foreign income tax imposed by country S on the sales branch’s profits would be allocated to the foreign base company sales income group and the foreign income tax imposed by country M on the manufacturing branch’s profits would be allocated to the tested income group. This, however, does not appear to be how the rules work. Because the CFC has both tested income and foreign base company sales income on the regarded sale, the foreign income tax imposed by country S should be apportioned between the tested income group and the foreign base company sales income group, even though country S may impose the foreign income tax solely on income that is treated as foreign base company sales income. This is because the reattribution rules expressly prevent reattribution of income away from a taxable unit from affecting how the foreign taxes imposed on a taxable unit are allocated and apportioned. See Treas. Reg. section 1.861-20(d)(3)(v)(B)(3). Applying the reattribution payment rules to disregarded payments provides an analogous apportionment of the foreign income tax imposed by the manufacturing branch’s jurisdiction. That is, if the reattribution payment rules apply to the disregarded payment from the sales branch to the manufacturing branch, the rules appear to assign a part of the disregarded payment to the CFC’s foreign base company sales income group within the general category, even though the manufacturing branch would derive tested income on a regarded sale of the property. This is because the reattribution payment rules reattribute part of the CFC’s income that is recognized for US tax purposes, i.e., the income derived from the customers, to the manufacturing branch, and the reattributed amount has the same character as the US gross income that is attributed. See Treas. Reg. sections 1.861-20(d)(2)(v)(B)(2), 1.951A- 2(c)(7)(ii)(B), 1.904-4(f)(2)(vi)(B)(2). As a consequence, the foreign tax imposed by country M would be apportioned in part to the CFC’s foreign base company sales income group and in part to the CFC’s tested income group.

Arguably, the rules would have better matched foreign income taxes to the income to which they relate by allocating all of the foreign income tax imposed by country S to foreign base company sales income and all of the foreign income tax imposed by country M to the tested income group. That said, the reattribution rules, as corrected, achieve better parity between the apportionment of the foreign income tax on the regarded sale and the apportionment of the foreign income tax on the disregarded sale. If the reattribution rules had not been corrected, it appears that the country S tax would have been apportioned between the foreign base company sales income group and the tested income group, while the country M tax would have been allocated entirely to the tested income group.

The corrections to Treas. Reg. section 1.861-20 also remove disregarded payments for property from the scope of “remittances” and “contributions.” That is, no portion of a disregarded payment in exchange for property can be a remittance or contribution. Accordingly, it is unnecessary to consider any reattribution asset in connection with a disregarded payment in exchange for property.

Corrections to cost recovery requirement

Taxpayers and practitioners had voiced concern that the cost recovery requirement, as modified by the Final Regulations, was overly stringent. The cost recovery requirement is one of the four requirements that a foreign tax must now satisfy to qualify as a creditable net income tax (the original three requirements were the realization requirement, the gross receipts requirement, and the cost recovery requirement, and, post-Final Regulations, the latest requirement is the attribution requirement). Under the Final Regulations, Treasury amended the cost recovery requirement to provide that a foreign net income tax must allow recovery of significant costs and expenses, and that costs and expenses “related to capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation are always treated as significant costs and expenses.” The cost recovery requirement contained an exception, whereby foreign tax law would be “considered to permit recovery of significant costs and expenses even if recovery of all or a portion of certain costs or expenses is disallowed, if such disallowance is consistent with the principles under the Internal Revenue Code, including disallowances intended to limit base erosion or profit shifting.” The cost recovery requirement also included several examples of such permitted disallowances -- limitations on interest deductions based on principles similar to those underlying section 163(j), disallowances of interest and royalty deductions in connection with hybrid transactions based on principles similar to those underlying section 267A, and disallowances of certain expenses based on public policy considerations similar to those disallowances contained in section 162. Taxpayers, however, were concerned that each disallowance under foreign law would have to have a corresponding counterpart in the Code disallowing the same deduction, and that the legislative history of the foreign law would have to show that the disallowance was intended to limit base erosion or profit shifting or was based on public policy concerns underlying section 162.

The Technical Corrections have loosened the cost recovery requirement, making it easier to meet. The italicized portion above has been changed to “consistent with any principle underlying the disallowances required under the Internal Revenue Code, including the principles limiting base erosion or profit shifting and public policy concerns.” While there may be room for interpretation, the amended sentence appears to say that, regardless of the foreign law’s intent underlying a disallowance, the foreign tax can meet the cost recovery requirement if the disallowances have the effect of limiting base erosion or profit shifting. This would widen the permissible disallowances to most cross-border payments, which would be consistent with Treasury’s reassurances that taxpayers were reading the cost recovery requirement too narrowly. Michael Rapoport, Treasury Tries to Calm Fears Over Foreign Tax Credit Rules, Daily Tax Report (July 26, 2022) (Treasury official explained that cost recovery requirement does not require a “one-to-one correspondence” between foreign and US law). The Technical Corrections also generalized the examples of acceptable disallowances to remove references to Code sections 163(j) and 267A, and clarified that a foreign tax can meet the cost recovery requirement even if the foreign tax law significantly delays the recovery of the cost of property until, for example, the taxpayer disposes of the property. Although not found in the text of the Technical Corrections, the IRS publicly clarified that the German license barrier rule should be considered consistent with the principles of base erosion and therefore allowable under the regulations. Andrew Velarde, IRS Tries to Address Some Concerns Over FTC Cost Recovery Rule, Tax Notes Today (April 1, 2022).

What was not addressed by the Technical Corrections

The Technical Corrections do not amend the most vexing aspect of the Final Regulations -- the attribution requirement for foreign withholding taxes on royalties, which requires that the royalties be sourced based on the place of use, or the right to use, the intangible property. Unless the foreign withholding tax qualifies as a creditable foreign tax under a treaty to which the United States is a party, the attribution requirement would make many previously creditable foreign withholding taxes on royalties no longer creditable because few countries source royalties based on place of use. We outlined our concerns regarding this requirement in Final FTC Regulations Cause Double Taxation – Burden(s) Fall on Taxpayers. Treasury officials have announced that a safe harbor for royalty withholding taxes is forthcoming in the form of a proposed regulation, though the specifics of the safe harbor have not been made public. Andrew Velarde, Treasury Likely to Issue FTC Regs’ Royalty Withholding Carveout, Tax Notes Today (May 23, 2022). By signaling that the change would be made through a proposed regulation, Treasury likely views the safe harbor as a substantive change that it would not have been able to make through the Technical Corrections.