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Taxnotes

Compulsory Payments Under the Final FTC Regulations

By: Brian H. Jenn & Mike Tenenboym


Brian H. Jenn is a partner and Mike Tenenboym is an associate at McDermott Will & Emery. They thank Jeffrey Maydew for his significant and helpful contributions to this article.

In this article, Jenn and Tenenboym explore how the new foreign tax credit regulations affect the compulsory payment rules.


New final foreign tax credit regulations have generated much controversy by limiting the kinds of foreign taxes that are creditable, but other changes made by the regulations also deserve careful attention; in particular, changes to the long-standing rules for determining when a payment to a foreign government is compulsory and thus potentially a creditable tax.1 As the overall global tax governance regime evolves and countries shift from traditional income tax incentives to other kinds of incentives, there may be additional circumstances in which the compulsory payment rules must be navigated.2


In this article we review what it means for a foreign income tax to be creditable, and then describe the compulsory payment rules, including the relevant changes introduced in the new regulations. Last, we detail the importance of these rules to U.S. multinationals and offer best practices to proactively approach compulsory payment issues.3


I. Creditable Foreign Taxes

Since 1918 the FTC regime has played the central role in mitigating double taxation for U.S. taxpayers.4 Without the ability to take a dollar-for-dollar credit — or at least 80 cents on the dollar, in the case of taxes attributable to global intangible low-taxed income — against U.S. federal income tax owed with respect to income, war profits, and excess profits taxes paid to foreign governments, and for specific taxes imposed in lieu of those foreign income taxes, double taxation could hobble the competitiveness of U.S. multinationals in foreign markets.


The FTC regime is one of the U.S. tax law’s most convoluted areas, and the determination of what constitutes a payment of “creditable tax” has become an increasingly important contributor to the complexity.5 In general, under the new regulations, after determining whether a foreign levy as generally applied meets the requirements to be considered a foreign income tax or “in lieu of” tax, it is necessary to further determine whether a specific amount paid in accordance with that foreign levy constitutes a payment of tax. An amount paid in accordance with a foreign levy that meets these requirements generally will be considered a foreign tax payment eligible for an FTC if (1) it is not refunded or credited back to the taxpayer;6 (2) it isn’t used to provide specific kinds of subsidies to the taxpayer;7 (3) it is a compulsory (not voluntary) payment;8 and (4) it isn’t a soak-up tax.9 The focus of this article is on the compulsory payment aspect of the analysis.


II. Compulsory Payments

The rule that an amount remitted to a foreign country must be a compulsory payment to be eligible for an FTC (the compulsory payment rule) is a bedrock principle of the FTC regime.10 The rule serves as a protective shield for the U.S. fisc — absent the compulsory payment rule, a taxpayer might be indifferent to remitting an amount to a foreign government in excess of what is required under foreign law.11 This would generally be the case when a domestic corporation has excess limitation in a particular section 904 category.12 In those cases, a taxpayer would be able to fully credit a foreign payment against its U.S. federal income tax liability, even if it constitutes an overpayment, effectively providing an indirect subsidy from the U.S. government to a foreign government.13


The new regulations, like the iteration of reg. section 1.901-2 that immediately preceded them (the prior regulations),14 articulate a test to determine whether a particular foreign payment satisfies the compulsory payment rule. They provide that “an amount remitted to a foreign country (a ‘foreign payment’) is not a compulsory payment, and thus is not an amount of foreign income tax paid, to the extent that the foreign payment exceeds the amount of liability for foreign income tax under the foreign tax law (as defined in paragraph (g) of this section).”15 The current version of the test is substantively similar to the version in the prior regulations, which provided: “An amount paid is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of liability under foreign law for tax.”16


To determine whether a foreign payment satisfies the compulsory payment rule, the new regulations, like the prior regulations, articulate a two-part test: (1) the amount must be determined in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign tax law (including treaties) in a way that reduces, over time, the taxpayer’s reasonably expected liability under foreign tax law for foreign income tax (the interpretation prong); and (2) a taxpayer must exhaust all “effective and practical” remedies, including competent authority procedures available under applicable tax treaties, to reduce, over time, its foreign income tax (including a liability in accordance with a foreign tax audit adjustment) (the exhaustion prong).


Although the test for purposes of the compulsory payment rule generally follows the version of the test described in the prior regulations, the new regulations provide additional gloss regarding when each of these elements is satisfied. For example, the test preserves the rule in the prior regulations that a taxpayer is not required to alter its form of doing business, its business conduct, or the form of any business transaction to reduce its foreign tax liability, yet now also provides that (1) satisfaction of each element will not take into account the present value of a deferred tax liability or other time value of money considerations;17 and (2) a taxpayer is not required to reduce its foreign income tax liability to the extent that it reasonably expects the arm’s-length costs of reducing the liability would exceed the amount by which the liability could be reduced, including when an additional liability would arise for a different (non-income) foreign tax.18


The first of the new rules clarifies that taxpayers must make nominal rather than real-value valuations when running the relevant cost-benefit analyses. The second rule is a welcome development compared with the iteration of the rule in prop. reg. section 1.901-2 (the proposed regulations), which could have eliminated taxpayers’ ability to factor in non-income-tax costs for the test used for purposes of the compulsory payment rule, but still isn’t as generous as the prior regulations, which required a taxpayer only to minimize foreign tax liability without regard to whether the relevant foreign income tax otherwise would be creditable.19 Those developments are explored further below, along with changes concerning the treatment of contested tax payments.


A. The Interpretation Prong

The new regulations preserve the general rule in the prior regulations that an interpretation or application of foreign tax law isn’t reasonable if there is actual notice or constructive notice (for example, a published court decision or binding administrative guidance) that the taxpayer’s interpretation or application of foreign tax law is likely incorrect. The new regulations also preserve the rule that, in interpreting foreign tax law, a taxpayer generally may rely on advice obtained in good faith from competent foreign tax advisers that have knowledge of the taxpayer’s relevant facts.20


The new regulations then go a step further by providing that, absent an exception, voluntarily forgoing a tax benefit that a taxpayer is otherwise entitled to under foreign tax law results in failure to satisfy the compulsory payment rule.21 That added language appears to be a permutation of the elections rule — that is, a situation in which a taxpayer forgoes exercising a foreign option or making an election that affects its foreign income tax liability over time.22 It shouldn’t, however, require a taxpayer to make any effort to arrange its affairs in a way that entitles it to a specific foreign tax benefit.23


As part of the interpretation prong, the new regulations also provide new, special rules for when a taxpayer forgoes a foreign option or election under foreign tax law (the elections rule), as well as updated rules for contested taxes.24 Historically, the elections rule was limited and taxpayer friendly — it effectively provided that options or elections that shift a taxpayer’s tax liability to a different year or years wouldn’t cause the taxpayer to fail the compulsory payment rule.25 In the proposed regulations, Treasury indicated that the prior regulations were unclear, specifically regarding whether the use of options or elections that result in an overall change in foreign income tax liability over time would result in a noncompulsory payment.26


The new regulations attempt to resolve the perceived lack of clarity by providing that an option or election that permanently decreases a taxpayer’s foreign income tax liability in the aggregate over time, if forgone, will result in failure of the compulsory payment rule. These rules generally apply on a taxpayer-by-taxpayer basis and obligate each taxpayer to make all reasonable efforts to minimize its liability for foreign income taxes over time to the greatest extent possible.


The new rules are relevant only to the taxpayer’s foreign income tax liability and don’t apply to options or elections in connection with a taxpayer’s choice of business form; maintenance of books and records on which income is reported; or the terms of contracts or other business arrangements.27 Further, the elections rule may reasonably be interpreted to not require applications for special regimes, especially when some element of discretion is allowed by a foreign tax authority or a taxpayer must satisfy substantive requirements to elect into the relevant regime.


Also, the new regulations provide three sets of circumstances in which the foreign elections rule wouldn’t compel a taxpayer to make or decline an election.28 The first circumstances involve an option or election regarding the treatment of an entity as fiscally transparent or not fiscally transparent.29 The second circumstance involves an option or election for one foreign entity to join in the filing of a consolidated return with another foreign entity, or to surrender its loss to offset the income of another foreign entity in accordance with a foreign group relief or other loss-sharing regime (for example, the U.K. Group Relief regime).30 Treasury’s rationale for not compelling elections in those circumstances is that the types of elections and options enumerated in the exceptions have the effect of shifting to another entity, rather than reducing in the aggregate, a taxpayer group’s foreign income tax liability, and therefore any inherent issues should be addressed under other rules.31


The third circumstance in which the foreign elections rule doesn’t apply involves foreign hybrid mismatch rules. In the hybrid mismatch exception, an increase in taxpayer A’s liability doesn’t raise an issue under the compulsory payment rule if A makes a payment to taxpayer B and that payment increases A’s liability for foreign income tax (for example, by waiving a deduction), which results in a greater decrease in B’s foreign income tax liability than the decrease that B would otherwise have under the deactivation of a hybrid mismatch rule.32 For this purpose, the term “hybrid mismatch rule” refers to foreign tax law rules substantially similar to sections 245A(e) and 267A and includes rules that are designed to eliminate deduction and no-inclusion outcomes of hybrid and branch mismatch arrangements.33 The new regulations cite the recommendations made by the OECD in action 2 as an example of such rules.34


The hybrid mismatch exception is especially welcome news given the European Union’s ongoing implementation of anti-tax-avoidance directives (ATADs) — in particular: (1) ATAD I, which generally addresses interest deduction limitations, controlled foreign corporation rules, and anti-hybrid rules; and (2) ATAD II, which generally addresses hybrid mismatches and specific permanent establishment issues.35 EU member states have discretion regarding the form and method of implementing the ATADs, provided minimum thresholds are satisfied.36


In some cases, implementation of ATAD-related legislation may result in a U.S. multinational forgoing specific elections to reduce its foreign income tax liability in the aggregate, despite the potential for additional foreign income tax liability at the subsidiary level at which the election is forgone. Thus, in the absence of the hybrid mismatch exception there would be a material risk that U.S. multinationals are subject to a punitive result. This is because if a subsidiary of a U.S. multinational exercises an option or election in a specific foreign country to reduce its foreign income tax liability in that country, the multinational as a whole may be subject to a higher overall foreign income tax liability, but if the subsidiary forgoes such an election, the multinational may not be able to claim FTCs regarding the “overpayment.” The hybrid mismatch exception is intended to mitigate this result.


B. The Exhaustion Prong

The new regulations preserve the general rule in the prior regulations that a remedy is effective and practical only if the cost of pursuing it (including the reasonably expected risk of incurring an offsetting or additional foreign income tax or other tax liability) is reasonable considering the amount at issue and the likelihood of success.37 The new regulations helpfully expand on that point, providing that an available remedy is considered effective and practical if an economically rational taxpayer would pursue it irrespective of FTC considerations — that is, it is unnecessary to pursue an ineffective remedy to demonstrate that one has “done something.”38


The new language — coupled with the language in the general rule that a taxpayer isn’t required to reduce its foreign income tax liability to the extent that the reasonably expected, arm’s-length costs of reducing the liability would exceed the amount by which the liability could be reduced — provide a basis for taxpayers to achieve more certainty regarding when the exhaustion prong is considered to be satisfied. That is because a taxpayer can affirmatively demonstrate that pursuing an additional remedy is too costly through a cost-benefit analysis — that is, presumably when the costs of pursuing additional remedies exceed the benefits, a taxpayer is treated as acting reasonably if it discontinues pursuing additional remedies. Finally, the new regulations preserve the rule that a settlement by a taxpayer of two or more issues will be evaluated on an overall basis, not on an issue-by-issue basis, to determine whether an amount constitutes a compulsory payment.39


C. New Rules Regarding Contested Taxes

Although not part of the compulsory payment rule, reg. section 1.905-1(d) introduces new rules for contested taxes that address similar issues to those addressed by the exhaustion prong. Before the new regulations, taxpayers largely relied upon Rev. Rul. 58-55, 1958-1 C.B. 266, and case law, which generally provided that a contested foreign tax accrues when the contest is resolved and the liability becomes finally determined, at which point the foreign tax is considered to accrue in the tax year to which it relates.40 The updated contested tax rules provide that, in general, a taxpayer cannot claim a credit for a contested tax before the contest is resolved.41


Treasury’s rationale for this rule is as follows: If a taxpayer can claim FTCs regarding contested taxes, it may lack incentives to resolve a foreign tax contest before the running of the U.S. statute of limitations42 for the U.S. tax year to which the foreign taxes relate.43 Thus, the general rule freezes creditability until the time the contest is resolved, at which point the amount of the liability is known with reasonable accuracy.44


Once the contest is resolved, the liability is treated as accruing in the earlier year in which it arose so that the taxpayer can claim an FTC for it in the relation back year.45 Significantly, as an alternative to the general rule, a taxpayer can elect to claim a provisional credit.46 Doing so allows a taxpayer to claim an FTC before the resolution of a tax contest. The cost of doing so is entering into an agreement under which the taxpayer commits that it won’t assert the statute of limitations as a defense to the assessment of additional taxes and interest if, after the contest has concluded, the IRS determines that the tax was not a compulsory payment.47 There are annual reporting requirements associated with this election.48


The contested tax rules may have especially interesting consequences in the transactional context. For example, companies that engage in public spinoffs generally put in place a tax matters agreement between the distributing and controlled corporations.49 Those agreements, in part, allocate the burden of foreign income taxes for pre-spin periods and assign responsibility regarding who will preside over tax contests. The allocation of a tax, and assignment of responsibility for managing contests, may take on heightened importance in light of the new rules.


As an example, assume there exists a domestic corporation, DC, which wholly owns a domestic corporation, DC2, which in turn wholly owns a country X corporation, FS. Further assume that in year 1 (1) FS incurs a foreign tax in country X; (2) FS remits payment to the government of country X and files a refund action with the appropriate authorities to contest the tax; and (3) DC properly claims a provisional FTC for the tax paid by FS (for example, claims the credit on its year 1 U.S. consolidated tax return, files a Form 1118, “FTC — Corporations,” for the claimed credit, and furnishes the agreement required by reg. section 1.905-1(d)(4)(ii)). Finally, assume that in year 2 DC distributes all of DC2’s stock in a section 355 distribution.


In this scenario, following the year 2 distribution, DC no longer retains any interest in FS. Given that DC2 itself didn’t claim a provisional credit for those taxes, DC2 may have no interest in directing FS to contest the previously paid foreign taxes, nor may DC2 comply with the requirements to preserve the provisional credit claimed by DC. Thus, absent a carefully drafted tax matters agreement, DC may lose its provisional credit (for example, DC2 may prematurely direct the conclusion of the FS tax contest so that the tax isn’t considered compulsory, or DC2 may fail to comply with the reg. section 1.905-1(d)(4)(iii) annual notice requirements).


To avoid those potential negative results, a distributing corporation, when entering into a tax matters agreement, should at a minimum (1) clarify who will oversee pre-distribution tax contests, and preserve veto rights regarding any tax contests that would negatively affect the distributing corporation; (2) ensure that the controlled corporation complies with any pre-distribution tax filing requirements (for example, the reg. section 1.905-1(d)(4)(iii) annual notice requirements) to preserve creditability; and (3) ensure that the controlled corporation provides access to needed documentation (for example, copies of a final judgment, order, settlement, or other documentation of the eventual contest resolution).50


III. Best Practices

To determine whether a payment will satisfy the compulsory payment rule, a first step would be for a U.S.-based company to assess whether it has reasonably interpreted foreign law in a way that minimizes foreign tax liability over time. This assessment begins with an evaluation of a foreign government’s position regarding an amount at issue — that is, by analyzing relevant foreign tax law (statutes, regulations, and case law).51 A company may perform this assessment internally if it has the requisite expertise to make a reasonable decision under applicable foreign tax law.52 In the absence of such expertise, or for a higher level of confidence, a U.S. multinational may consider an opinion from qualified foreign counsel that (1) details the relevant legal authorities, and (2) concludes that the amount in question was properly assessed.53 The opinion path may be especially helpful when there is substantial gray area regarding whether the relevant foreign payment is compulsory under foreign tax law.


Caution is advisable as a company considers whether to forgo foreign tax benefits, or to make specific elections in the foreign countries in which its subsidiaries operate. As discussed above, absent an exception, forgoing benefits, elections, or options may result in a foreign payment being considered “noncompulsory” and thus non-creditable.


Even if a company believes it has made a reasonable determination under foreign tax law that a payment is compulsory, further efforts are required in the event of a dispute with a foreign tax authority. For purposes of the exhaustion prong, a taxpayer bears the burden of proof to demonstrate all effective and practical remedies to contest a foreign tax liability have been exhausted.54 In this regard, documenting the basis for such a conclusion is important.


When there is a concern that a specific foreign payment may not be considered compulsory under foreign tax law or the relevant foreign government is pursuing what is believed to be an unreasonable action regarding a foreign payment made, a useful approach is to model out the pertinent costs associated with contesting the liability. These costs would certainly include legal and accounting fees, the costs associated with extensive discovery, and possible interest and penalties. Less obvious but potentially relevant costs could include management time, the implications of a long-running controversy for other pending tax matters, or, for the taxpayer’s relationship with the foreign tax authority, regulatory consequences and reputational issues.


Also, the cost of a settlement that involves payment of foreign non-income taxes (for example, value added taxes, transaction taxes, or custom duties) may be taken into account. If the costs of pursuing the action exceed the benefits, consider receiving an opinion from counsel regarding the same.55 Further, if after assessing the potential costs a determination is made that some actions are in order, one starting point is to make a refund claim regarding the amount at issue. If the refund is rejected but there is a strong position on the merits or the foreign government’s position regarding the amount at issue is considered unreasonable, the next course of action can be to pursue an administrative appeal or court challenge.56


If a treaty is applicable to a specific tax liability, the calculus likely changes. In general, a taxpayer must claim treaty benefits when applicable, and can do so by filing a foreign tax return, making a refund claim, or objecting to a foreign assessment, for example.57 Competent authority assistance should also be considered, including in cases involving two non-U.S. treaty parties.58 That is the case even if the relevant foreign country’s statute of limitations has lapsed or other foreign country administrative remedies have failed.59 From a U.S. standpoint, the steps for invoking competent authority are described in Rev. Proc. 2006-54, 2006-2 C.B. 1035.60 Through competent authority assistance, a mutual agreement procedure may be secured.61 Contrary to most taxpayers’ experience, the IRS considers the cost of competent authority assistance to be “generally low,” and therefore, absent evidence to the contrary (for example, an opinion from counsel), the option of pursuing competent authority assistance ought to be evaluated in that light.62 With that said, sometimes competent authority assistance isn’t required — for example, when (1) the amount at issue in the case is de minimis; (2) other administrative remedies or litigation are successful; or (3) there is an opinion of local counsel.63


A successful MAP negotiation occurs when an agreement is reached between the two treaty states (contracting states) on the relevant issues. If a MAP is successful, the IRS generally considers the exhaustion prong satisfied.64 In contrast, if a MAP negotiation is unsuccessful and competent authority assistance does not resolve the case, the IRS may still consider the payment noncompulsory if the facts are such that other administrative or judicial action may resolve the case in favor of the taxpayer.65


Regardless of the path taken, documenting the efforts undertaken is important. For example, the IRS may cite the following as evidence that a payment was not compulsory: (1) the taxpayer took actions (or omitted to take specific actions) that precluded the effectiveness of competent authority assistance;66 (2) the taxpayer entered into a closing agreement with a foreign government on unreasonable terms, and thereby prevented the U.S. competent authority from getting involved in the case;67 or (3) the taxpayer knew or should have known that the statute of limitations for requesting a refund or pursuing other recovery actions for a foreign payment would lapse, but no action was taken.68 To that end, it is always helpful to document actions and preserve documentation in the records, such as copies of original and amended foreign returns and books and records associated with those returns (for example, receipts/documentation of taxes paid, foreign transfer pricing adjustments, settlement agreements, or competent authority disposition letters). It is also important to take care in completing U.S. tax filings, particularly Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” and Form 1118.


IV. Conclusion

Although compulsory payment rule issues frequently arise in the transfer pricing adjustment context, their potential impact is not so limited. For example, compulsory payment issues may arise in a host of other situations in which there is not a neat overlap of U.S. and foreign tax law, such as when (1) withholding tax rates are reduced by treaty; (2) characterization of income rules are inconsistently applied (for example, nontaxable sale gain characterization versus withholding tax on royalty characterization); (3) expense allocation rules are inconsistently applied (for example, there are different amounts of taxable income attributable to a branch under foreign tax law); (4) economic activity does not give rise to PE status; or (5) different source of income rules lead to conflicting or overlapping claims of primary taxing jurisdiction.69


Potential changes in the U.S. international tax rules, if enacted, may bolster the importance of FTCs — for example, by applying the GILTI provisions on a country-by-country basis (so that taxpayers that formerly had excess GILTI credits may come to have residual GILTI tax in some jurisdictions) or reducing the haircut on FTCs for GILTI purposes.70 Also, in a post-pandemic world, companies can expect more frequent and aggressive foreign tax audits as cash-strapped foreign governments are eager to fill their depleted coffers.71


Taxpayers will do well to be on the lookout for compulsory payment issues that may not have been so prominent in the past, keeping in mind that the new regulations offer some helpful clarifications when such issues arise.


FOOTNOTES

1 T.D. 9959. The new regulations generally apply to tax years beginning on or after December 28, 2021, and follow the issuance of prop. reg. section 1.901-2 in 2020. See REG-101657-20. The new regulations further implement and address changes made by the Tax Cuts and Jobs Act.

2 Although not detailed here, the coming implementation of OECD initiatives (pillars 1 and 2) should only further complicate the FTC analysis. See OECD, “Statement on a Two-Pillar Solution to Address the Tax Challenges Arising From the Digitalisation of the Economy” (Oct. 8, 2021). Pillar 1 is generally designed to (1) reallocate specific residual profits to “market jurisdictions” where revenues are earned, but an enterprise may not have a physical presence; and (2) account for specific marketing and distribution activities on a non-arm’s-length basis, applying a fixed return concept. Pillar 2 is generally designed to implement a 15 percent global minimum corporate tax.

3 Domestic corporations are a type of person that is eligible for FTCs. Section 901(b)(1).

4 See Revenue Act of 1918, 40 Stat. 1057 (1919). See also, e.g.Burnet v. Chicago Portrait Co.285 U.S. 1 (1932).

5 For example, penalties, fines, interest, or similar obligations are not taxes, nor is a customs duty a tax. Reg. section 1.901-2(a)(2)(i).

6 See reg. section 1.901-2(e)(2).

7 See reg. section 1.901-2(e)(3).

8 See reg. section 1.901-2(e)(5).

9 See reg. section 1.901-2(e)(6).

10 The first iteration of the compulsory payment rule appeared in proposed regulations issued in 1979: 44 F.R. 36071 (June 20, 1979) (“in order for a charge to be a tax for purposes of sections 901 and 903, payment of the charge must be compulsory and must not be compensation for a specific benefit . . . a payment is compulsory only if made pursuant to a legal liability to a foreign government”). The compulsory payment rule underwent several modifications between 1979 and 1983, and thereafter generally remained the same until the issuance of the new regulations. See 45 F.R. 75647 (Nov. 17, 1980); 48 F.R. 14641 (Apr. 5, 1983); 48 F.R. 26272 (Oct. 12, 1983).

11 See, e.g., S. Rep. No. 67-275, at 17 (1921) (providing that the FTC shouldn’t “wipe out” tax properly attributable to U.S.-source income); REG-156779-06 (providing that the compulsory payment rule “ensures that a taxpayer will make reasonable efforts to minimize its foreign tax liability even though the taxpayer may otherwise be indifferent to the imposition of foreign tax due to the availability of the foreign tax credit”); and IRS, “LB&I International Practice Service Process Unit — Audit,” at 3 (audit practice unit) (providing that, absent the compulsory payment rule, “taxpayers would otherwise have no incentive to challenge any foreign tax whether or not properly imposed, thereby transferring the foreign tax cost to the United States”).

12 A taxpayer’s section 904 limitation is a function of the ratio of its foreign-source income to worldwide taxable income, multiplied by its U.S. income tax liability. See section 904.

13 See, e.g., Jason Yen, “Noncompulsory Payment Rule Raises Transfer Pricing Issues for Disregarded Entities and Branches,” Tax Mgmt. Int’l J. (Feb. 14, 2014).

14 Reg. section 1.901-2(a)(2) and (e)(5). The prior regulations were generally finalized in T.D. 9634.

15 Reg. section 1.901-2(e)(5)(i).

16 Reg. section 1.901-2(e)(5).

17 REG-101657-20 (providing that then-prop. reg. section 1.901-2(e)(5)(i) “clarifies that the time value of money is not relevant in determining whether a taxpayer has met its obligation to minimize the amount of its foreign income tax liabilities over time,” and explaining that the rule is designed to avoid otherwise complex and burdensome computations for taxpayers and the IRS).

18 Reg. section 1.901-2(e)(5)(i).

19 Prop. reg. section 1.901-2(e)(5)(i) (providing no special rule for foreign non-income taxes). See also REG-101657-20.

20 Reg. section 1.901-2(e)(5)(ii).

21 Id.

22 Reg. section 1.901-2(e)(5)(iii).

23 See reg. section 1.901-2(e)(5)(ii).

24 Although not discussed in detail herein, it’s worth noting that the new regulations provide helpful examples of how these rules should apply. See reg. section 1.901-2(e)(5)(vi).

25 Reg. section 1.901-2(e)(5)(i) (2021) (“Where foreign tax law includes options or elections whereby a taxpayer’s tax liability may be shifted, in whole or part, to a different year or years, the taxpayer’s use or failure to use such options or elections does not result in a payment in excess of the taxpayer’s liability for foreign tax.”).

26 REG-101657-20 (“the regulations are not clear as to whether the use or failure to use options or elections that result in an overall change in foreign income tax liability over time would result in a noncompulsory payment”). The rule appears to make explicit what was implicit under the prior regulations — i.e., failing to use an election to reduce tax over time could result in a specific levy being treated as non-creditable.

27 Id. (providing that the changes to the elections rule “do not require taxpayers to modify any other conduct that may have tax consequences, including, for example, choices relating to business form or the maintenance of books and records on which income is reported, or the terms of contracts or other business arrangements”).

28 Reg. section 1.901-2(e)(5)(iii). Also, a special rule is provided in the context of multiple levies. Reg. section 1.901-2(e)(5)(iii)(C) (providing that if the option is regarding the determination of foreign income tax liability under one of multiple separate levies, each of which qualifies as a foreign income tax liability, the amount of foreign income tax paid equals the smallest liability of the amounts that would be due under each of the alternative levies, regardless of which levy the taxpayer uses to determine its foreign income tax liability).

29 Reg. section 1.901-2(e)(5)(iii)(B)(1).

30 Reg. section 1.901-2(e)(5)(iii)(B)(2).

31 REG-101657-20 (“Because these elections and options generally have the effect of shifting to another entity, rather than reducing in the aggregate, a taxpayer group’s foreign income tax liability, the Treasury Department and the IRS have determined that foreign tax credit concerns related to the use or failure to use such an election or option are more appropriately addressed under other rules.”). Other rules implicated may include the section 909 “splitter” rules, which address the circumstances under which loss-sharing regimes can result in application of section 909.

32 Reg. section 1.901-2(e)(5)(iv)(A).

33 Reg. section 1.901-2(e)(5)(iv)(B).

34 Id.

35 See Council Directive (EU) 2016/1164 (July 12, 2016) (providing that ATAD I should generally be implemented by EU member states through legislation by December 31, 2018); Council Directive (EU) 2017/95 (May 29, 2017) (providing that ATAD II should generally be implemented by EU member states through legislation by December 31, 2019).

36 See article 288 of the Treaty on the Functioning of the European Union.

37 Reg. section 1.901-2(e)(5)(v).

38 Id.

39 Id.

40 See, e.g.Cuba Railroad Co. v. United States124 F. Supp. 182 (S.D.N.Y. 1954) (providing that a contested tax resolved in a year later than the year of payment (1943) related back to 1943); Albermarle Corp. & Subsidiaries v. United States797 F.3d 1011 (Fed. Cir. 2015) (holding that when the relation back doctrine applied, the statute of limitations for filing a refund claim began from the unextended due date for the return for the year to which the tax related, and not the later year in which the contest was resolved).

41 Reg. section 1.905-1(d)(3). The general rule operates under the theory that the amount is not finally determined until the contest is resolved. See also, e.g.section 461(f); reg. section 1.461-2(a)(2)(i); Dixie Pine Products Co. v. Commissioner320 U.S. 516 (1944).

42 A special 10-year statute of limitations applies for purposes of claiming a credit or refund of U.S. tax that is attributable to foreign income taxes for which an FTC is claimed under section 901. Reg. section 301.6511(d)-3See also reg. section 1.905-1(c)(2). For accrual basis taxpayers, the 10-year period runs from the unextended due date of the return for the tax year in which the foreign income taxes accrued within the meaning of reg. section 1.905-1(d). Reg. section 1.905-1(c)(3).

43 T.D. 9959 (“Permitting taxpayers to claim a credit for contested taxes before the contest is resolved reduces the incentive for taxpayers to continue to pursue the contest and exhaust all effective and practical remedies if the period of assessment for the year to which the taxes relate has closed and the IRS would be time-barred from disallowing the FTC claimed regarding the contested tax paid on noncompulsory payment grounds.”).

44 Reg. section 1.905-1(d)(1)(i).

45 Reg. section 1.905-1(d)(1)(ii). This is especially relevant in the context of foreign tax redeterminations. A foreign tax redetermination occurs when there is a change in a taxpayer’s foreign income tax liability that affects previously claimed FTCs. See section 905(c)(1).

46 Reg. section 1.905-1(d)(4) (providing that a provisional credit can be claimed if requirements are satisfied, such as claiming the credit on the relevant U.S. tax return, filing a Form 1118, “FTC — Corporations,” and satisfying specific annual notice requirements). A taxpayer can make an election to claim an FTC, but not a deduction, for the contested foreign income taxes. Reg. section 1.905-1(d)(4)(i).

47 Reg. section 1.905-1(d)(4)(ii).

48 Reg. section 1.905-1(d)(4)(iv).

49 See section 355.

50 Reg. section 1.901-1(d)(4)(iv)(C). Separately, contested tax issues (inclusive of exhaustion of remedies issues) may arise when a company merges or acquires another company, particularly when a foreign party is involved that has limited U.S. operations and therefore may have paid little attention to the compulsory nature of foreign payments it previously made.

51 See, e.g., audit practice unit, supra note 11, at 9.

52 See, e.g.id. at 11; Procter & Gamble Co. v. United StatesNo. 1:08-cv-00608 (S.D. Ohio 2010) (holding that a taxpayer couldn’t claim an FTC regarding Korean withholding tax imposed on royalties when the withholding tax had already been paid to Japan because the taxpayer failed to exhaust available remedies under Japanese law and the Japan-U.S. tax treaty).

53 See, e.g., audit practice unit, supra note 11, at 11.

54 See, e.g., IRS, “LB&I International Practice Service Transaction Unit,” at 16 (last updated Aug. 28, 2014).

55 See, e.g., audit practice unit, supra note 11, at 11 (providing that a taxpayer can obtain an opinion letter that explains why a challenge to an assessment is unlikely to be successful).

56 See, e.g., reg. section 1.901-2(e)(5)(vi)(A)-(C).

57 See, e.g., audit practice unit, supra note 11, at 13.

58 See, e.g., id. Competent authority provisions in treaties should be reviewed to understand the relevant limitations periods and which filings are required to preserve access to the relevant competent authority as a means of potentially obtaining treaty relief.

59 See, e.g.id. at 13 (providing that “even if the local statute of limitations has passed or other administrative remedies fail, the taxpayer should invoke competent authority proceedings”).

60 TRE/C/016_12-10 (knowledge practice unit), at 3 (providing that “‘competent authority process’ refers to all steps in the process of initiating and resolving a competent authority case, including steps in relation to pre-filing procedures. See section 1.04 of Rev. Proc. 2015-40, 2015-35 IRB 236. The competent authority process is represented by paragraphs 1 and 2 of the MAP article in most U.S. income tax treaties.”).

61 Id. (the “competent authority process provides broad access to a mechanism under the [MAP] article of a U.S. income tax treaty to alleviate double taxation (and other taxation not in accordance with the treaty). See section 2.01(2) of Revenue Procedure (Rev. Proc.) 2015-40.”).

62 Audit practice unit, supra note 11, at 14 (“Because the cost of pursuing competent authority relief is generally low, taxpayers that fail to seek competent authority assistance where available must produce evidence to show why it would not have been an effective and practical remedy.”).

63 Id. at 19.

64 Id. at 17, 20.

65 Id. at 15.

66 Id.

67 Id. at 16.

68 Id. at 8. In contrast, if the statute of limitations lapses but the company didn’t have actual or constructive notice of it, the lapse by itself shouldn’t cause failure of the compulsory payment rule.

69 For detailed examples that may present compulsory payment issues, see transaction practice unit, supra note 54 (providing examples of how a compulsory payment rule issue may arise in the following scenarios: (1) different withholding tax treatment; (2) inconsistent characterization of debt and equity; and (3) inconsistent country characterization of U.S.-provided information technology services versus royalties).

70 See Build Back Better Act (H.R. 5376). This bill has been passed by the House but not the Senate. Among other things, it would change the rules regarding FTCs — for example, by (1) allowing a temporary five-year carryforward for GILTI FTCs; (2) reducing the haircut on GILTI FTCs from 20 percent to 5 percent; and (3) repealing the one-year carryback allowance for FTCs attributable to non-GILTI foreign income taxes.

71 Taxpayers are already experiencing more frequent and aggressive foreign tax audits. See, e.g., audit practice unit, supra note 11, at 9.

Company Tax Notes
Category FREE CONTENT;ARTICLE / WHITEPAPER
Intended Audience CPA - small firm
CPA - medium firm
CPA - large firm
Published Date 05/24/2022

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