Why the Foreign Tax Credit Regulations Kerfuffle Won't Be Going Away

The Department of the Treasury’s December 2021 final foreign tax credit regulations are looking to be its most despised rules in years. They’ve been blasted by business groups, accountants, and lawmakers from both sides of the aisle for allegedly overstepping the department’s legal authority and upending years of prior precedent. From recent memory, only the Obama administration’s earnings stripping/intercompany debt rules from 2016 might do worse in a popularity contest.

The wait for the next controversy like this, however, may not be as long. In the context of the increasingly complex and evolving international landscape, the foreign tax credit regs look less like a one-time flareup and more like a harbinger of what’s to come.

Many practitioners have scoffed when Treasury stated that the regulations are focused on denying credits to digital services taxes, or other novel levies targeted at new online transactions. The scope of the regulations cover everything from royalties and interest payments to withholding taxes, and will affect income from much more traditional businesses. They could also potentially reverse decades of earlier determinations on which foreign taxes are creditable, long before anyone fired off a Google search.

Foreign tax credits are a simple concept, going back nearly 100 years–income shouldn’t be taxed twice by two different governments. While nations have agreed to transfer pricing principles to establish common ways to allocate income across jurisdictions, they don’t always agree on which government has the right to tax it. Some countries tax on the basis of the source of income, some on the residence of the taxpayer, and most do a bit of both. The U.S., as a country which taxes all of the worldwide income of its taxpayers, offers taxpayers credits when that income has already been taxed overseas.

But the credits are only supposed to apply to taxes on income–a sometimes tricky concept to define. In recent years, European countries have claimed that the traditional measures of taxable income, which often included a requirement for physical presence, do not capture the modern, online digital economy. Many of them (allegedly on a temporary basis) enacted digital services taxes on revenue from some digital activities, such as advertising, data collection or e-retail. These don’t resemble any concept of income taxation, since they don’t take into account costs at all. But their proponents claimed they were a proxy for the income falling through the cracks of the outdated system.

Other countries looked at different ways to achieve similar results. Some expanded the definition of permanent establishment, or a taxable nexus, to capture more companies doing business from outside their jurisdictions. Others increased withholding taxes on outgoing related-party payments from digital services. All of these new levies diverged from traditional definitions of taxable incomes, and most tended to shift away from residence-based taxation to source-based taxation. After all, in this ethereal online world, the one thing that can be pinned down to reality most of the time is the user sitting at a computer.

Or, more cynically, it’s always politically easier to tax foreign entities than to tax your own.

The Organization for Economic Cooperation and Development’s digital tax project is meant to be a consensus solution to this dilemma, to convince countries to repeal their digital taxes. That may be a long, winding and uncertain road–and in the meantime, the levies remain.

Whether digital services taxes ought to be creditable was a policy discussion that has apparently been resolved–they shouldn’t be, as far as Treasury is concerned. If the regulations stopped there, they likely would have gone into effect with much less commotion.

But the rules went much further, laying out new tests and definitions for taxpayers to determine whether an income tax is diverging too much from the standard definition, as the U.S. sees it.

One of the most controversial provisions in the regulations was the jurisdictional nexus requirement, a new rule to ensure that there is “a sufficient nexus between the foreign country and the taxpayer’s activities or investment of capital or other assets that give rise to the income being taxed,” according to proposed regulations issued in 2020.

“A tax imposed by a foreign country on a taxpayer’s income that lacks a sufficient nexus to such country (such as the lack of operations, employees, factors of production, or management in that foreign country) is not an income tax in the U.S. sense and should not be eligible for a foreign tax credit if paid or accrued by U.S. taxpayers,” the regulations stated.

While this requirement isn’t in any of the prior regulations, the department argued that it was always an implicit part of the foreign tax credit law.

“As a dollar-for-dollar credit against U.S. income tax, the foreign tax credit is intended to mitigate double taxation of foreign source income,” Treasury stated. “This fundamental purpose is served most appropriately if there is substantial conformity in the principles used to calculate the base of the foreign tax and the base of the U.S. income tax.”

The final regulations re-named the rule the “attribution requirement,” but kept most of the language, brushing aside comments that they were overstepping their legal authority. To be creditable, a foreign tax “must determine the amount of income subject to tax based on the nonresident’s activities located in the foreign country (including its functions, assets, and risks located in the foreign country),” based on either U.S. tax law or OECD guidance. Taxes on income from interest, rents and royalties must also be sourced similar to U.S. law.

The regulations have several other new rules which aren’t directly related to nexus, or to novel taxes, but follow the theme of fine-tuning the definition of income and nixing credits to foreign taxes that no longer qualify. There are new cost recovery rules to evaluate how foreign taxes consider costs in the calculation of income. And it repeals the “predominant character test,” a decades-old principle that a foreign tax should be evaluated on its “predominant character,” in favor of more expansive new tests.

Big picture-wise, you get a sense of both why Treasury felt they had to go on this route, and why it’s generated a much-larger-than-usual backlash. They could have identified extra-territorial digital services taxes and singled them out as non-creditable, and that likely would have satisfied everyone. But that could have left them drafting new rules in a few more years, to deal with whatever new virtual taxes crop up. They opted instead to come up with a broader framework to distinguish income and non-income taxes, that could work for these new questions but also negated prior distinctions set by precedent or formalistic determinations that were good enough for years. A new world requires new rules.

Like most Treasury rules, they're a mix of tricky, broad subjective questions about principles and imperfect, cumbersome blunt dictates aiming to best approximate the outcomes they want. Both, though, are putting new and unwelcome burdens on taxpayers, including an obligation to fully investigate and interpret foreign tax systems to learn whether or not they qualify for credits which may determine whether or not the jurisdiction is worth operating in.

The Internet’s big contribution to the world was to reduce friction in daily life. This has brought inestimable benefits, but in recent years we’ve become more and more attuned to the costs. Scammers can reach exponentially more potential victims. Addictive tendencies are brought out more easily and permanently. Folks can broadcast whatever vile, offensive thought first hits their cortex, before their better nature can kick in.

And practical, real-world distinctions that governments used as the basis for tax enforcement are being brushed aside. Once upon a time, physical presence was a near-perfect determinant of economic activity, and it was easy to tell the difference between a sales tax and an income tax without delving into the philosophy of it. But in the digital, online world, it’s often difficult to determine something’s nature without asking about its abstract attributes–what does it really do?

In this new world, there seems to be a tendency to drift towards source-based, transaction-based taxation, leading to a blurring of the distinction between consumption and income taxes.

“The key issue is that the core principle at the heart of consumption taxes–namely the destination principle–is arguably more suitable to a globalized and digitalized economy,” Rita de la Feria, a professor at the University of Leeds School of Law and an expert on both corporate and consumption taxation, wrote to me in an email. “Both as a matter of equity principle (market jurisdiction matters more and more), and as matter of efficiency principle (in a mobile world, the least mobile factor of production is consumers).”

It’s not just the DSTs that have been using consumption tax principles as a proxy for the income tax–the same basic idea lies at the heart of the OECD’s Pillar 1 agreement, which is meant to satisfy the market countries and convince them to repeal their digital levies. Pillar 1 allows countries to tax a percentage of income from sales in their jurisdiction, regardless of whether the taxpayer has a physical presence or not.

While the taxing mechanism of Pillar 1 is complicated enough, one of the biggest challenges that OECD officials are still tackling is how to devise rules to prevent overlap with the existing tax system. It's yet another example of how the blurriness between consumption and income taxes is creating exponentially more paperwork for tax officials from government and business alike.

On the FTC regs, Treasury has rebuffed requests for a delay. But it recently released corrections giving taxpayers some flexibility--which the department insists is a clarification of what was in the original rules. In testimony to the Senate Finance Committee and the House Ways and Means Committee last month, Secretary of the Treasury Janet Yellen held firm that they would not be reversing or pulling the final regulations.

However this is resolved, taxpayers should expect to be dealing with these issues for a long, long time.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

OTHER NEWS OF THE WEEK

Can you move forwards and backwards at the same time? While Republican lawmakers and conservative activists meet with Hungary officials about blocking implementation of the OECD's global minimum tax/Pillar 2 at the EU, the U.K. forges ahead with its own legislation. This is why I wonder what Pillar 2 opponents think their endgame is--they may stop the "critical mass" of participants from forming, but they'll never stop everyone from enacting Pillar 2 taxes. If the U.S. stays out, it risks losing some of its leverage over the details. (Like challenging countries which overstep the OECD standards.) The biggest hurdle for Pillar 2's supporters, including the Biden administration, is clearly explaining all of this to the key deciders, when there are too many moving parts for even the experts to keep track of.

The OECD released a new batch of rulings from the Forum on Harmful Tax Practices, as part of an initiative from the 2015 BEPS 1.0 project.  Tax incentives from Pakistan and Armenia were determined to be "potentially harmful," in part because they do not include requirements for substantial real activities. This is a reminder that while the high-profile Two-Pillar Solution/global min tax project appears stalled, the rest of the OECD's work to crack down on profit-shifting and problematic tax structures continues.

Speaking of the OECD, coinciding with a Senate hearing on tax incentives in housing policy, the organization released a report, "Housing Taxation in OECD Countries." There seems to be growing recognition for policymakers on the left and right that housing costs are a major driver of inequality, and to a large degree housing policy is tax policy. Worth a look if you're trying to stay on top of emerging topics in global taxes.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Red Rube, created by Ed Robbins for Zip Comics of MLJ Magazines in 1943. A young orphan, Rueben Rueben, ran off to a haunted castle. But he found that the ghosts were all his ancestors, and they gave him superpowers which he could summon by yelling "Hey Rube!" (Similar to a certain other shapeshifting superhero who was the subject of a famous legal dispute.) Looks like his ghost ancestors forgot to give him a shirt. Rueben eventually became a reporter for the Daily Sun.