It has probably been a long time, if ever, since any US final regulations caused an uproar to those involved in cross-border investments involving Brazil and the United States. The new final regulations (TD 9959) is of special concern to US outbound investments, as well as Brazilian investors who started (or broadened) their US operations by “flipping” their structures by inserting a U.S. parent company on top of one or more Brazilian entities.
To make matters worse, most of the rules in the final regulations are effective beginning on or after December 28, 2021.
Unlike Brazil, US tax rules and academics do not spend much time discussing what is income for tax purposes. US rules are much more practical in this regard.
The new final regulations detailed the changes of what it takes to be a creditable foreign income tax for US tax purposes. It may be debatable whether the final regulations could go this far, but regardless it is the current law, so investors and businesses need to familiarize themselves with the new reality.
Previous proposed regulations had created an additional requirement, labeling it “jurisdictional nexus requirement”, which the final regulation rebranded as “attribution requirement”.
The Final Regulations, under § 1.901-2(a)(ii), sets out that a foreign tax is a foreign income tax only if it is a foreign tax and either (1) the foreign tax is a net income tax or a (2) a tax in lieu of an income tax.
According to the regulations, under §1.901-2(b)(2) through (4), a foreign tax qualifies as an income tax if it meets the following requirements: realization, gross receipts, and cost recovery tests. The recovery test was modified by the Final Regulations. Also, by reading the regulations one cannot help think that adverse impacts of the final regulations on US investments abroad will grow when the foreign country’s law is not sufficiently similar to the U.S. federal income tax. Nonresidents and residents in the foreign country are subject to separate attribution rules.
The decision process on whether any particular foreign tax is creditable is made separately regarding each foreign levy.
Since Brazil and the United States have not signed a double tax treaty, the sections of the regulations that include caveats for treaty rules were intentionally left off.
What the Final Regulations Left Untouched
Although the complexity of the new rules requires some time assess the depth of their impacts, it seems that foreign income tax applicable to the net income of a foreign corporation or an individual whose business is in the same foreign country is still creditable for US tax purposes. E.g., both IRPJ and CSL could still be accepted as creditable foreign income taxes if paid by a Brazilian entity (IRPJ and CSL) whose business income was generated from business activities carried out in Brazil.
The New Attribution Rules: nonresidents in the foreign country
Regarding nonresidents to the foreign country, the applicable attribution rule requires that the foreign tax base meet at least one of three possible nexus tests, i.e. the activities test, the source test, or the situs test. See § 1.901-2(b)(5)(i)(A) through (C).
The activities test (i.e., income attribution based on activities) requires the gross receipts and costs included in the foreign base to be attributable, under reasonable principles, to the nonresident’s activities within the foreign country imposing the tax (including the nonresident’s functions, assets, and risks located in the country).
The final regulations define reasonable principles as rules similar to those for determining effectively connected income, while excluding rules that take into account as a significant factor the mere location of customers, users or any other similar destination-based criterion, or the mere location of persons from whom the nonresident makes purchases.
Under the source test, the income included in the foreign tax base and the foreign country sourcing rules must be reasonably similar to the US tax rules found in the Internal Revenue Code. Thus, regarding services, foreign tax must source gross income based on where the services are performed. Here, the regulations clarifies that if the foreign law elects place of performance based on the location of the service recipient, the foreign tax not creditable in the US.
Foreign tax on royalties must be sourced based on the place of use of, or the right to use, the intangible property.
As for sales of property, gross income arising from gross receipts from sales or other dispositions of property (including copyrighted articles sold through an electronic medium) must be included in the foreign tax base on the basis of the activities test or the situs test (i.e., not on the basis of source test).
In the case of the situs test, the nonresident may only include gross receipts attributable to the disposition of real property situated in the foreign country imposing the foreign tax (or of an interest in a legal entity, corporation or passthrough, that owns such real property) under rules reasonably similar to US FIRPTA.
The regulations goes on to say that a foreign tax imposed on the basis of the situs of property may include in its base gains derived from the disposition of property forming part of an active business with a taxable presence in the foreign country, as well as gains from the disposition of an interest in a passthrough entity that has a taxable presence in the foreign country if the gains are attributable to the entity’s business property in that foreign country, under rules that are reasonably similar to the US rules on effectively connected income. In other words, gains on property used in an active business should be taxed as ordinary income on a net basis.
The New Attribution Rules: Residents of the Foreign Country
The final regulations allow the foreign tax base of the tax on residents of the foreign country to be based on worldwide income, but any allocation to or from the resident of income, gain, deduction, or loss with respect to transactions between such resident and organizations, trades, or businesses owned or controlled directly or indirectly by the same interests is determined under arm’s length principles. I.e., the allocation must be made under the foreign country’s transfer pricing rules. However, these allocations cannot take into account, at least not as a significant factor, the location of customers, users, or any other similar destination-based criterion.
This can be specially troublesome since Brazil has historically resisted adopting the arm’s length principle under its transfer pricing rules.
Taxes in lieu of income taxes – § 1.903–1
The final regulations clarify that a foreign tax either is or is not a tax in lieu of an income tax in its entirety for all persons subject to the tax. Further, it is immaterial whether the base of the in lieu of tax bears any relation to realized net gain.
The policy reasons why a foreign country impose its tax on a base other than net income (for example, because of administrative difficulty in determining the amount of income that would otherwise be subject to a net income tax) is deemed immaterial. However, § 1.903–1(c)(1) generally requires a showing that the foreign country made a deliberate and cognizant choice to impose the in lieu of tax instead of a net income tax.
More specifically, a foreign levy is a tax in lieu of an income tax only if (i) it is a foreign tax; and (ii) it satisfies the substitution requirement. The substitution requirement requires a foreign tax (the ‘‘tested foreign tax’’) to satisfy, based on the foreign tax law, 4 requirements under § 1.903–1(c)(1)(i) through (iv), or the tested foreign tax is a covered withholding tax. These 4 requirements are as follows:
1) Existence of a separate generally-imposed net income tax in the foreign country: a separate levy that is a net income tax must be generally imposed by the same foreign country that imposes the tested foreign tax.
2) No net income tax is also imposed, in addition to the tested foreign tax, by the same foreign country on any persons with respect to any portion of the income to which the amounts (such as sales or units of production) that form the base of the tested foreign tax relate (the ‘‘excluded income’’).
3) Close connection to excluded income: this is probably one of trickiest requirements. Basically, it sets out that the generally-imposed net income tax would otherwise have been imposed on the excluded income but for the existence of the tested foreign tax. The imposition of such tested foreign tax bears a close connection to the failure to impose the generally-imposed net income tax on the excluded income. The relationship cannot be merely incidental, tangential, or minor.
A close connection requires proof that the foreign country made a cognizant and deliberate choice to impose the tested foreign tax instead of the net income tax. Such proof must be based on foreign tax law, or the legislative history of either the tested foreign tax or the generally-imposed net income tax that describes the provisions excluding taxpayers subject to the tested foreign tax from the net income tax.
Thus, a close connection exists if the generally-imposed net income tax would apply by its terms to the excluded income, but for the fact that the excluded income is expressly excluded. Also, the tested foreign tax is enacted contemporaneously with the net income tax. In case the tested foreign tax is not enacted contemporaneously with the net income tax, a close connection can be established only by reference to the legislative history of the tested foreign tax (or a predecessor in lieu of tax).
4) Jurisdiction to tax excluded income: if the net income tax, or a hypothetical new tax that is a separate levy, were applied to the excluded income, such net income tax or separate levy would meet the attribution requirement.
Alternatively, to these 4 requirements above, the tax in lieu of income tax may be a ‘covered withholding tax’. Withholding is creditable for “covered withholding taxes” if the tax is imposed on nonresidents, doesn’t duplicate a regular income tax (i.e., the foreign tax cannot apply to gross income of nonresidents that are also subject to a net income tax imposed by the same country on the same income), and meets the source-based attribution test. In practice, the source test will come down to checking if the foreign law sourcing rules are “reasonably similar” to those under the US Internal Revenue Code.
The example that indicates what to expect for withholding taxes on royalties
An illustration of foreign withholding tax on royalties is found under § 1.903–1 (d)(4), example 4: YCo, a resident of Country Y, is a controlled foreign corporation wholly-owned by USP, a US corporation. In Year 1, YCo grants a license to XCo, a resident of Country X unrelated to YCo or USP, for the right to use YCo’s intangible property (IP) throughout the world, including in Country X. Under Country X’s law, all royalties paid by a resident of Country X to a nonresident are sourced in Country X and are subject to a 30% withholding tax on the gross income, regardless of whether the nonresident payee has a taxable presence in Country X. Country X’s withholding tax on royalties is a separate levy, and XCo only uses the IP in Country X.
The final regulations goes on to say that the foreign tax is not creditable because Country X’s source rule for royalties (based upon the residence of the payor) is not reasonably similar to the US sourcing rules. The withholding tax paid by YCo does not meet the attribution requirement, nor is the Country X withholding tax paid by YCo covered withholding tax. Here, it is easy to see the same outcome if Brazil is either country Y or country X.
Key points (so far):
The final regulations are full of examples that indicate that the new service taxes created in some countries will probably not be creditable in the United States.
Brazilian investors and businesses will probably have more reasons to worry about outbound payment for services and royalties to the United States. Services are sourced at the place of provision, whereas royalties are at the place of use of the intangible.
In Brazil, the 15% withholding tax on payments for services provided by a US company in the United States,for the benefit of a Brazilian business, will likely not be creditable.
Withholding on royalties’ payments from Brazil will only be creditable if the intangible is used or explored in Brazil. However, it is possible the foreign tax credit is disallowed because the Brazilian withholding tax applies on outbound payments of royalties regardless if the intangible is used or explored in Brazil.
Withholding on interest payments from Brazilian debt is still expected to be creditable.
Written by Roberto P. Vasconcellos, Senior Tax Associate at Drummond Advisors