On November 12, 2020, the IRS and the Treasury released draft foreign tax credit regulations, introducing a new jurisdictional link requirement under existing section 1.901-2 (c) of the Treasury Regulations. (Proposed Treas. Reg. Section 1.901-2, 85 FR 72078). This new requirement has been criticized by many business groups and law firms, arguing that it could lead to double taxation.
The measure was proposed to respond to the proliferation of new unilateral taxes adopted by countries deviating from traditional tax rules, such as taxes on digital services. It explicitly targets rules such as the consumer-based linkage of taxes on digital services.
The jurisdictional link requirement would be added to the definition of an income tax under Article 901 of the Tax Code. The proposed rule would require, for articles of the tax code 901 and 903, that the foreign tax law establishes a sufficient connection between the foreign country and the activities or investment of the taxpayer in the foreign country giving rise to the taxable income so that the foreign tax can be deducted from the US tax.
From an international tax perspective, the proposed jurisdictional requirement is incompatible with the principles of the foreign tax credit and detrimental to current discussions on the taxation of digital services.
History of article 901
Existing Sections 901 and 903 allow an income tax credit and taxes in lieu of income tax paid or accrued in a foreign country.
According to an original reading of Section 901, Congress did not require a jurisdictional connection requirement for a foreign tax to be credited. The current section 901 provides that a credit is allowed for any “tax on income, war profits and excess profits paid or accrued during the taxation year to any foreign country or to any possession of the States. -United”. Section 903 includes taxes paid “in lieu of income tax” within the meaning of Section 901 of income tax.
Congress enacted several changes to the foreign tax credit regime. Among the most significant changes, Congress introduced in 1921 a first “blanket limitation” limiting the liability of foreign tax to US tax on foreign source income. In 1986, Congress amended the limitations of the foreign tax credit by requiring that the foreign tax credit be calculated in different categories of income (baskets) (see item). Historically, Congress has never provided a jurisdictional link requirement, with limitations on foreign tax liability to US tax being limited to considerations of source and amount.
Principle of the jurisdictional link requirement
The jurisdictional link requirement aims to limit the tax credit for these types of foreign taxes by excluding them from the definition of income tax. Prop. Treas. Reg. Section 1.901-2 requires foreign tax to comply with current US tax rules in order to be credited. For a foreign tax to be considered an income tax, “the tax must conform to established international standards, reflected in the Internal Revenue Code and related guidelines, for the distribution of profits among associated enterprises, for the attribution of the commercial profits of non-residents to a taxable presence. in the foreign country, and for the taxation of cross-border income according to the source or the situs of the goods (together, the “jurisdictional link requirement”) ”.
For non-residents of the foreign country, income subject to foreign tax must satisfy a different link depending on the type of income. The first link is an attribution of income based on the activity link. The second link is based on the source of income, and the third link is based on the property’s situs. The proposal expressly excludes any link that would be based on the location of customers, recipients of the service or any criteria based on destination (Prop. Treas. Reg. Section 1.901-2).
Nexus requirement incompatible with avoidance of double taxation
When enacting the foreign tax credit, it was suggested that Congress sought to reduce double taxation and promote the competitiveness of U.S. businesses (see item). Article 901 of the tax code provides a tax credit for any income tax paid or accrued in a foreign country. The purpose of the foreign tax credit is to reduce double taxation. See American Chicle Co. v. United States.
Since the original purpose of the tax credit is to provide relief to U.S. taxpayers doing business in foreign countries, the Treasury’s intention to restrict the credibility of the foreign tax might seem politically unwarranted. .
From the point of view of treaties, Article 23 of the United States Model Tax Convention provides relief from double taxation in the form of a tax credit against the United States for income tax paid or accrued in the other Contracting State. However, the provision limits the tax credit available under US law. Here, it must be determined whether a jurisdictional link requirement, limiting the availability of the tax credit, would change the general principle established by Section 901 as enacted by Congress and, if so, would be contrary to the law. double taxation relief offered by the United States. treaty model.
Article 23B of the OECD model convention grants a tax credit paid on income or capital, if the convention provides for the taxation of such income. A question may arise as to whether the unilateral charges referred to in the proposed regulation are charges within the meaning of the Convention. Since OECD Comments Regarding the article recommending granting double tax relief despite qualification issues, the Treasury’s proposal to limit the credibility of certain foreign taxes in response to recently enacted taxes may appear inadequate.
Questions regarding the current debate on the taxation of the digital economy
The proposed jurisdictional link requirement is intended to deter the adoption of unilateral taxes such as taxes on digital services. On the other hand, proposals on the taxation of the digital economy are currently being examined at the international level within the OECD under pillars 1 and 2 and within the UN.
OECD pillar 1 intends to rewrite the rules on the nexus and profit distribution of large multinational enterprises (MNEs) taking into account new business models and to extend the taxing rights of market jurisdictions (which, for some business models , is based on the user’s location).
According to a OECD statement, “In the digital age, the attribution of taxing rights and taxable profits can no longer be exclusively circumscribed by reference to physical presence. Therefore, a jurisdictional link requirement that relies primarily on traditional physical activity and source linkage would no longer be solely relevant when considering new business models and would run counter to current efforts to combat taxation. of the digital economy.
OECD pillar 2 proposes to ensure that international companies pay a minimum amount of tax regardless of their place of incorporation or place of activity. The we also pushed the idea of a global minimum tax. The Pillar 2 proposals differ in that they are based on an income threshold and an effective minimum tax rate to be determined. If the Pillar 2 proposals are adopted, these tax inclusions could lead to double taxation and, if necessary, raise the question of their credibility.
Contrary to current OECD discussions, the UN recently approved in April 2021 a new Article 12B for the United Nations Model Tax Convention on revenues from automated digital services that would allow withholding at source for the State of source on gross payments for automated digital services. Such a proposal would depart from traditional international tax rules. If countries were to implement such a withholding tax on revenues from automated digital services, it would have to be determined whether, in the same way, it would qualify under a jurisdictional link rule.
The jurisdictional link requirement proposed in Prop. Treas. Reg. Section 1.901-2 seeks to limit the credibility of certain foreign taxes vis-à-vis US tax in response to the proliferation of unilateral taxes, such as taxes on digital services, adopted by several countries.
A jurisdictional link requirement that limits the credibility of a foreign tax might not deter the adoption of new taxes and lead to more harm to U.S. taxpayers doing business in foreign countries, as it could raise several double taxation issues. It also does not anticipate the current proposals on the taxation of the digital economy and their future implications. In its current form, this jurisdictional link requirement is fundamentally opposed to the very principle of the primary intent of the foreign tax credit: reduction of double taxation.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Nathalie Nguyen ([email protected]) is a student at the University of Florida Levin College of Law.