The preamble to final regs (T.D. 9959) issued January 4 pulls no punches in denying U.S. foreign tax credits for a foreign country’s destination-based taxes imposed on U.S. taxpayers.
The new regs finalize proposed regs published in November 2020 (REG-101657-20) that included rules for determining whether a foreign tax is eligible for an FTC under section 901.
The regs include a jurisdictional nexus requirement to exclude customer or user locations as adequate nexus. In defense of that exclusion, the preamble lays out a passionate and comprehensive assault on destination-based taxes.
Jurisdictional Nexus
The regs provide that foreign taxes imposed on nonresident taxpayers satisfy the jurisdictional nexus requirement if they meet one of three nexus tests based on activities, income source, or property situs.
The activities nexus test is met if the tax is imposed only on income attributable to activities in the foreign country. The allocation of a nonresident’s income to activities in the foreign country can’t take into account the location of customers, users, or any similar destination-based criterion.
To have source-based nexus, the foreign sourcing rules must be reasonably similar to U.S. sourcing rules. To have property-based nexus, the tax must be imposed on gain from the disposition of either real property in the foreign country or movable business property of a taxable presence in the foreign country.
Commentators questioned the validity of the jurisdictional nexus requirement as inconsistent with the language, structure, and legislative history of the FTC provisions. Treasury countered that adding a jurisdictional nexus requirement is a valid exercise of its rulemaking authority.
U.S. tax law has long incorporated a jurisdictional nexus limitation in taxing income of foreign persons. The FTC rules reflect international norms that assign the primary right to tax to the source country, the secondary right to the country where the taxpayer is a resident or engaged in business, and the residual right to the country of citizenship or place of incorporation.
The net gain requirements further reflect jurisdictional norms in limiting creditable taxes to those imposed on net income and limiting the scope of receipts and costs that may be included in the base of a creditable foreign income tax.
Absent the nexus requirements, U.S. tax on net income could be reduced by FTCs for a foreign levy inflating its tax base by unreasonably assigning income to a taxpayer or by not deducting costs attributable to gross income in the tax base.
Commentators have said the jurisdictional nexus requirement is contrary to the policy underlying the FTC. Double taxation results when the United States taxes income taxed by another country regardless of whether the other country has adequate nexus. Treasury argued that allowing an FTC for tax on amounts without nexus could convert the FTC regime into a subsidy for foreign governments at the expense of the U.S. fisc.
The FTC’s purpose is to relieve double taxation by having the United States cede its own taxing rights only when the foreign country has the primary right to tax income.
Determining the receipts and costs included in the foreign tax base is inherent to determining whether a foreign tax is an income tax in the U.S. sense.
Mitigating double taxation is best served if there is substantial conformity in the principles used to calculate the foreign and U.S. tax bases. The regs require the foreign tax to conform with established international jurisdictional norms reflected in U.S. law.
Destination-Based Taxes
After laying out the rationale for jurisdictional nexus, the preamble explains why destination-based taxes are an unreasonable abandonment of international norms:
Recently, many foreign jurisdictions have disregarded international taxing norms to claim additional tax revenue, resulting in the adoption of novel extraterritorial taxes that diverge in significant respects from U.S. tax rules and traditional norms of international taxing jurisdiction. These extraterritorial assertions of taxing authority often target digital services, where countries seeking additional revenue have chosen to abandon international norms to assert taxing rights over digital service providers.
As a result of those actions, Treasury deemed it necessary and appropriate to adapt the section 901 and 903 regs to address that change in circumstances, especially for a digital services sector that didn’t exist when the FTC provisions were first enacted.
The regs clarify the circumstances in which a tax is ineligible for an FTC as a result of a foreign jurisdiction’s unreasonable assertion of jurisdictional taxing authority.
Commentators disagreed that destination-based tax rights lack sufficient connection to a jurisdiction, noting Congress’s prior deliberations on destination-based taxes, U.S. participation in OECD negotiations on base erosion and profit shifting, and the several U.S. states that use sales-based apportionment factors to determine liability for corporate income tax. Treasury found none of those considerations sufficient to consider destination-based taxes eligible for an FTC.
While Treasury acknowledged in the proposed regs that future changes in U.S. law might require rethinking the requirements for creditable foreign income tax, “it was nevertheless important that these final regs be issued promptly to address novel extraterritorial taxes.”
In rejecting a delay in issuing the regs, Treasury said there would be “an immediate and detrimental impact on the U.S. fisc” if those “novel extraterritorial taxes, which many foreign jurisdictions have already adopted, are being paid by taxpayers and claimed as an FTC.”
The new regs make clear that income arising from services must be sourced based on where the services are performed and that reasonable principles do not include determining the place of performance based on the service recipient’s location.
Foreign withholding taxes on income from services not performed in the foreign jurisdiction isn’t consistent with an income tax in the U.S. sense and won’t qualify for an FTC under section 901.
In the end, Treasury protected the U.S. fisc from unreasonable and novel extraterritorial assertions of taxing jurisdiction that have no activity- or source-based nexus.