1.901-2 Requirements for a Creditable Foreign Tax

The U.S. foreign tax credit prevents taxpayers from being taxed twice on the same income: once by a foreign country and again by the United States. This relief is not automatic, as a foreign tax must be “creditable” to reduce a taxpayer’s U.S. liability. The standards for what constitutes a creditable tax are governed by U.S. Treasury Regulations. These rules ensure a foreign levy is equivalent to an income tax in the U.S. sense by scrutinizing its structure, ensuring that only taxes on net income or profits receive a credit.

Defining a Foreign Tax

Before a foreign levy can be tested as an income tax, it must first be classified as a “tax.” This involves clearing two hurdles established in Treasury Regulation §1.901-2. The first is the compulsory payment requirement. A payment to a foreign government is not a tax to the extent that the amount paid exceeds the taxpayer’s actual legal liability under the foreign country’s laws.

For example, if a U.S. company operating abroad fails to claim an allowed business expense deduction, the portion of the foreign tax paid attributable to that forgone deduction is a noncompulsory payment and is not creditable. Taxpayers are expected to take all reasonable steps to minimize their foreign tax liability over time.

The second hurdle is the “specific economic benefit” rule. A payment is not a tax if it is made in exchange for a specific economic benefit from the foreign government, such as a license to extract minerals. This rule distinguishes general revenue-raising taxes from payments that are fees for a particular right or service.

This is complicated for “dual-capacity taxpayers”—those who both pay a general income tax and receive a specific economic benefit. In such cases, the regulations require the taxpayer to separate the payment into the portion that is a creditable tax and the portion that is a non-creditable payment for the economic benefit.

Determining the Separate Levy

Once a payment is determined to be a compulsory tax, the next step is to identify the precise “separate levy” that must be analyzed. A single foreign tax statute can contain multiple distinct taxes, and each must be evaluated independently for creditability. A levy is considered separate from another if it is imposed on a different tax base.

For example, a country’s tax on a corporation’s business profits and a separate withholding tax on dividends paid by that corporation are two separate levies. The base for the corporate profits tax is net income, while the base for the dividend withholding tax is a gross payment, requiring separate analyses.

Furthermore, a single levy is treated as multiple separate levies if it is imposed on different classes of taxpayers under distinct rules. A foreign country might impose a 15% withholding tax on interest paid to non-residents on a gross basis, while residents are taxed on that same interest as part of their overall net income. Because the rules for calculating the tax differ, they are treated as two separate levies.

The Net Gain Requirement

For a separate levy to be a creditable income tax, it must be structured to tax net gain. This net gain requirement ensures the foreign tax is aimed at a taxpayer’s net profits, similar to the U.S. income tax system. The foreign levy must meet four components: realization, gross receipts, cost recovery, and attribution.

The Realization Requirement

The realization requirement dictates that the foreign tax must be imposed on or after an event that would trigger the realization of income under U.S. tax principles. Realization events include sales, exchanges, or other dispositions of property, as well as the receipt of payments. A tax imposed on the mere appreciation in an asset’s value before it is sold would fail this test.

A foreign tax may be imposed on a pre-realization basis if the foreign law includes a mechanism to recapture any previously taxed appreciation upon a later disposition. For example, if a foreign law taxes unrealized gains but provides a credit or basis adjustment to prevent double taxation when the asset is sold, it may still satisfy the requirement.

The Gross Receipts Requirement

The gross receipts requirement mandates that the base of the foreign tax must be computed starting with actual gross receipts. If the tax base is not determined by actual receipts, it must be calculated using a method not likely to produce an amount greater than the fair market value of those receipts. This rule prevents the creditability of taxes based on fictional amounts of income.

A foreign tax imposed on the deemed value of goods sold, where that value is consistently higher than the actual sales price, would likely fail this test. The requirement accommodates certain formulary taxes if the formula is a reasonable proxy for actual gross receipts.

The Cost Recovery Requirement

A foreign tax must permit the recovery of significant costs and expenses attributable to the gross receipts included in the tax base. Final regulations issued in 2022 tightened this standard. Under these regulations, the foreign tax law must provide for the recovery of all significant costs, and the methodology for this recovery must be consistent with U.S. tax principles.

A foreign law disallowing deductions for expenses that are deductible in the U.S. could cause the entire tax to become non-creditable. For example, if a foreign country’s tax law denies a deduction for interest paid to a related party, the tax may fail the cost recovery requirement. The analysis is based on the terms of the foreign law itself, not on whether a particular taxpayer actually incurs the disallowed expense. The mere existence of a provision that systematically denies the recovery of a significant cost can disqualify the tax.

The Attribution Requirement

A significant change from the 2022 regulations is the addition of an attribution requirement. This component acts as a nexus test, requiring the foreign tax law to have rules that attribute profits to the taxing jurisdiction in a manner consistent with U.S. tax principles. The foreign law must connect the income it taxes to the taxpayer’s activities or property within that country. The regulations provide three specific, acceptable bases for attribution.

First is an activities-based nexus, which applies to income from services or other activities. The foreign law must attribute the income based on the location where the taxpayer’s activities occur. Second is a source-based nexus, which applies to income like interest and royalties. For a withholding tax on royalties to be creditable, the foreign law must source the royalty income to the place where the intangible property is used. This has rendered many foreign withholding taxes on royalties non-creditable, as many countries source royalties to the location of the payer, not the location of use.

The third acceptable basis is a property-based nexus for income from the disposition of property. The foreign law must attribute gains to the location of the property, including the seller’s residence for certain personal property or the physical location for real property.

In response to the challenges these cost recovery and attribution rules created, the IRS has provided temporary relief. This guidance allows taxpayers to apply the more flexible creditability rules that were in place prior to 2022. Consequently, many foreign taxes that would be non-creditable under the new standards may continue to qualify for the foreign tax credit while this relief is in effect.