U.S. Treasury Issues Technical Corrections to Final Foreign Tax Credit Regulations

August 2022

BY

Michael MasciangeloNational Tax Office, International Tax Practice Leader

Tiffany IppolitoNational Tax Office, International Tax Managing Director

The Department of the Treasury on July 26 released a set of technical corrections to the recently released final foreign tax credit (FTC) regulations. While the technical corrections – 2022-15867 and 2022-15868 – make several benign updates, Treasury’s primary focus was to alleviate taxpayer concerns regarding the potentially restrictive application of the cost recovery test for purposes of determining the creditability of foreign taxes. (For prior coverage of the final FTC regs, see BDO’s January 2022 alert).

The technical corrections also address some aspects of the final regulations relating to disregarded payments made by entities that aren’t recognized as separate from their owner for tax purposes and make minor modifications to those rules.

The corrections apply retroactively.
 

Cost Recovery Test

Under the final regulations, to determine whether a foreign tax is creditable for U.S. tax purposes, the foreign tax must meet a “net gain requirement” that includes four tests: (1) realization; (2) gross receipts; (3) cost recovery; and (4) attribution. The cost recovery test in turn requires a foreign country to permit the recovery of significant costs and expenses attributable to gross receipts and provides a list of per se significant costs and expenses, such as wages, capital expenditures, royalties, and rents. Taxpayers expressed concerned that the cost recovery test, as written in the final regulations, would require the foreign country’s laws regarding cost recovery to be exactly the same as the U.S. laws in order for the foreign tax to qualify as a creditable tax. 
 

Key Technical Corrections 

Although Treasury officials have routinely stated that the cost recovery test was not intended to be so restrictive and that foreign law would not necessarily have to be the same as U.S. law, the technical corrections intend to make that position official. Specifically, the Treasury updated the final regulations – specifically, Treas. Reg. §1.901-2 – to remove the word “significant” and insert “including capital expenditures.” Moreover, the technical corrections indicate that foreign law is 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 general disallowances under the Internal Revenue Code (IRC), such as limiting base erosion or profit shifting and public policy concerns. 

The technical corrections provide that that a foreign tax is considered to permit recovery of significant costs and expenses if the foreign tax law:
  • Limits interest deductions based on a measure of taxable income.
  • Disallows deductions in connection with hybrid transactions.
  • Disallows deductions attributable to gross receipts that in whole or in part are excluded, exempt or eliminated from taxable income.
  • Disallows certain deductions based on public policy considerations similar to those underlying the disallowances included in IRC Section 162.
 

Future Expected Guidance

Another area of concern for taxpayers since the release of the final regulations has been the creditability of royalty withholding taxes as a result of a narrowing of the rule, potentially resulting in the disallowance of a foreign tax credit for such withholding taxes. Treasury is expected to release a new proposed rule that would provide a safe harbor in those cases. The safe harbor would provide welcome relief for taxpayers and is expected to be released, according to the Treasury, in the next months.
 

How BDO Can Help

The technical corrections provide an expected and welcome broader reading of the rules surrounding cost recovery. Given the retroactive nature of the technical corrections, taxpayers should consider this guidance for provision purposes and assess whether these clarifications could result in any necessary FTC changes. 

The FTC rules and final regulations are highly complex. BDO can help multinational taxpayers navigate these rules and regulations to ensure compliance and help identify growth opportunities.