Overseas Tax Credit score Laws: Nexus As The New Credo – Capital Features Tax

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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
the taxpayer is a resident of the foreign country. Foreign tax paid
by nonresidents of the foreign country meets the attribution
requirement if there is nexus based on one or more of the following
criteria: activities, sourcing rules, or property.

Attribution to Nonresidents

Activities-Based Nexus

Activities-based nexus requires that only gross receipts and
costs reasonably attributable to the nonresident’s activities
in the foreign country are included in the tax base.6
Such activities can include “functions, assets, and risks
located in the foreign country.” In general, attribution is
reasonable if it follows principles similar to those set out in
Code §864(c), which sets rules for determining effectively
connected income (“E.C.I.”). This means that gross
receipts cannot be taken into account as part of the tax base if
they are sourced based on the location of customers or users, or of
people from whom the nonresident makes purchases. This requirement
excludes rules that tax a taxpayer based on the activities of
another person, including a trade or business or permanent
establishment created by another person, unless that other person
is an agent for or a flow-through entity owned by the taxpayer. In
essence, this follows the holding in Miller v. Commr.,7
a case that held a foreign corporation did not have U.S.-source
income or effectively connected income when it was a subcontractor
of a U.S. related party having a contract with a U.S. customer and
all activities of the foreign corporation were performed outside
the U.S.

Source-Based Nexus

Source-based nexus is twofold.8 First, income that is
included based on source is limited to income sourced to the
foreign country. Second, the foreign country’s sourcing rules
must be similar to U.S. sourcing rules. In response to criticism,
the final regulations require reasonable similarity but not
complete conformity to U.S. sourcing rules for foreign persons.
Specific rules are provided for three types of income:

  • Income from services must be sourced to the place of
    performance, which cannot be based on the service recipient’s
    location.
  • Royalties must be sourced to the place of use or right to use
    the intangible property.
  • Income from sales of property is completely excluded from
    eligibility for source-based nexus. If a taxpayer wants a foreign
    tax credit for such income, the foreign tax rule must fit either
    activities-based or property-based nexus.

Property-Based Nexus

Property-based nexus is the only way to meet the attribution
requirement for a foreign tax imposed by a foreign country on
nonresidents based on the situs of property, including ownership in
a corporation or flow-through entity.9

Property-based nexus requires comparison to two provisions of
U.S. tax law. First, with regard to real property, creditable
foreign tax is limited to sums raised under rules similar to
F.I.R.P.T.A., which imposes U.S. tax on foreigners holding U.S.
real property. The second concerns tax incurred through disposition
of property other than shares in a corporation, but including
interests in a partnership, and based on the situs of property
other than real property. Creditable foreign tax is limited to sums
attributable to property that forms part of the business property
maintained by the nonresident in the foreign country, as determined
by rules similar to the E.C.I. rules under U.S. tax law.

Attribution to Residents

Wider latitude is provided for a foreign tax imposed on
residents of the foreign country imposing the tax. The foreign tax
on all of a resident taxpayer’s worldwide income will pass the
attribution requirement.10 However, the foreign tax
rules must require that income between the resident and affiliated
entities (i.e., income subject to transfer pricing rules) be
calculated under arm’s length principles. As with attribution
to nonresidents, the tax cannot take into account destination-based
criteria.

Income Tax Treaties

Tax treaties sometimes override domestic law, and the final
regulations, to an extent, provide for that. If the article on
relief from double taxation in a tax treaty between the U.S. and
the foreign country treats a foreign tax as an income tax, that tax
will be considered an income tax. However, such relief is limited
to U.S. residents. A more limited form of relief is available to
C.F.C.’s.

APPLICATION

Mr. A is a U.S. person who, through two tiers of flow-through
entities, owns and operates a resort in Spain. He does not reside
there. The resort is owned directly by a Spanish flow-through
entity, which is owned by a Danish flow-through entity. Mr. A
decides to sell the resort by selling all of his interests in the
Danish entity. The transaction results in the imposition of Spanish
capital gains tax at 19%, the rate for nonresidents, based on the
underlying real property being located in Spain. There is no Danish
tax liability.

Footnotes

1 See the I.R.S. website.

2 Treas. Reg. §1.901-2(b)(2)(i).

3 Treas. Reg. §1.901-2(b)(3).

4 Treas. Reg. §1.901-2(b)(4)(i).

5 T.D. 9959.

6 Treas. Reg. §1.901-2(b)(5)(i)(A).

7 T.C. Memo 1997-134, aff’d without pub. op., 166 F3d
1218 (9th Cir. 1998).

8 Treas. Reg. §1.901-2(b)(5)(i)(B).

9 Treas. Reg. §1.901-2(b)(5)(i)(C).

10 Treas. Reg. §1.901-2(b)(5)(ii).

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