[Federal Register Volume 87, Number 224 (Tuesday, November 22, 2022)]
[Proposed Rules]
[Pages 71271-71286]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-25337]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-112096-22]
RIN 1545-BQ46


Guidance Related to the Foreign Tax Credit

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to the 
foreign tax credit, including guidance with respect to the 
reattribution asset rule for purposes of allocating and apportioning 
foreign taxes, the cost recovery requirement, and the attribution rule 
for withholding tax on royalty payments.

DATES: Written or electronic comments and requests for a public hearing 
must be received by January 23, 2023.

ADDRESSES: Commenters are strongly encouraged to submit public comments 
electronically. Submit electronic submissions via the Federal 
eRulemaking Portal at www.regulations.gov (indicate IRS and REG-112096-
22) by following the online instructions for submitting

[[Page 71272]]

comments. Once submitted to the Federal eRulemaking Portal, comments 
cannot be edited or withdrawn. The Department of the Treasury (the 
``Treasury Department'') and the Internal Revenue Service (the ``IRS'') 
will publish for public availability any comment submitted 
electronically, and on paper, to its public docket. Send hard copy 
submissions to: CC:PA:LPD:PR (REG-112096-22), Room 5203, Internal 
Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 
20044. Submissions may be hand delivered Monday through Friday between 
the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-112096-22), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, 
Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.901-2 and 
1.903-1, Teisha Ruggiero, (646) 259-8116; concerning Sec.  1.861-20, 
Suzanne Walsh, (202) 317-4908; concerning submissions of comments and 
requests for a public hearing, Regina Johnson, (202) 317-6901 (not 
toll-free numbers) or by sending an email to [email protected] 
(preferred).

SUPPLEMENTARY INFORMATION: 

Background

    On December 17, 2019, the Treasury Department and the IRS published 
proposed regulations (REG-105495-19) addressing changes made by the Tax 
Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054 (2017)) (the 
``TCJA'') and other related foreign tax credit rules in the Federal 
Register (84 FR 69124) (the ``2019 Foreign Tax Credit (``FTC'') 
proposed regulations''). Correcting amendments to the 2019 FTC proposed 
regulations were published in the Federal Register on May 15, 2020 (85 
FR 29368). The 2019 FTC proposed regulations were finalized as part of 
TD 9922, published in the Federal Register (85 FR 71998) on November 
12, 2020 (the ``2020 FTC final regulations''). On the same date, the 
Treasury Department and the IRS published proposed regulations (REG-
101657-20) in the Federal Register (85 FR 72078) (the ``2020 FTC 
proposed regulations''). The 2020 FTC proposed regulations addressed 
changes made by the TCJA and other foreign tax credit issues. 
Correcting amendments to the 2020 FTC final regulations were published 
in the Federal Register on October 1, 2021 (86 FR 54367). A public 
hearing on the 2020 FTC proposed regulations was held on April 7, 2021. 
The 2020 FTC proposed regulations were finalized in TD 9959, published 
in the Federal Register (87 FR 276) on January 4, 2022 (the ``2022 FTC 
final regulations''). Correcting amendments to the 2022 FTC final 
regulations were published in the Federal Register on July 27, 2022 (87 
FR 45018 and 87 FR 45021).
    This document contains proposed regulations (the ``proposed 
regulations'') addressing the following issues: (1) the definition of a 
reattribution asset for purposes of allocating and apportioning foreign 
income taxes; (2) the application of the cost recovery requirement; and 
(3) the application of the source-based attribution requirement to 
withholding taxes on certain royalty payments.

Explanation of Provisions

I. Allocation and Apportionment of Foreign Income Taxes

A. In General
    Section 1.861-20 provides rules for allocating and apportioning 
foreign income taxes to the statutory and residual groupings, including 
the categories described in section 904 that apply for purposes of 
calculating a taxpayer's foreign tax credit limitation. In general, 
Sec.  1.861-20 operates by first assigning the foreign gross income on 
which the foreign income tax is imposed to statutory and residual 
groupings based upon the character of the item of U.S. gross income 
that corresponds to the foreign gross income (the ``corresponding U.S. 
item''). Sec.  1.861-20(c) and (d). Foreign income tax expense is 
allocated to the grouping to which the foreign gross income is 
assigned, and if foreign gross income is assigned to more than one 
grouping, deductions computed under foreign law are allocated and 
apportioned to the groupings and foreign tax expense is apportioned 
among the groupings based upon foreign taxable income in the groupings. 
Sec.  1.861-20(e) and (f).
    The 2022 FTC final regulations provide rules for allocating and 
apportioning foreign income tax arising from a disregarded payment. 
Foreign gross income included by reason of the receipt of a disregarded 
payment has no corresponding U.S. item because Federal income tax law 
does not give effect to the payment as a receipt of gross income. 
Section 1.861-20(d)(3)(v) therefore characterizes the disregarded 
payment under Federal income tax law for purposes of assigning this 
foreign gross income to the statutory and residual groupings. These 
rules treat the portion of a disregarded payment, if any, that causes 
U.S. gross income of the payor taxable unit to be reattributed under 
either Sec.  1.904-4(f)(2) (in the case of a taxpayer that is an 
individual or domestic corporation) or Sec.  1.951A-2(c)(7)(ii)(B) (in 
the case of a taxpayer that is a foreign corporation) to the recipient 
taxable unit as a ``reattribution payment.'' Sec.  1.861-
20(d)(3)(v)(E)(7); see also part I.B of this Explanation of Provisions 
for a description of the reattribution payment rules. The excess of a 
disregarded payment over the portion that is a reattribution payment is 
treated either as a contribution from one taxable unit to another 
taxable unit owned by the first taxable unit, or as a remittance of a 
taxable unit's current and accumulated earnings. Sec.  1.861-
20(d)(3)(v)(E)(2) and (8). Section 1.861-20(d)(3)(v)(D) provides a 
special rule for characterizing disregarded payments that are made in 
exchange for property and are not reattribution payments.
B. Reattribution Payments, Remittances, and the Reattribution of Assets
    Section 1.861-20(d)(3)(v)(B) assigns foreign gross income from a 
disregarded payment that is a reattribution payment to the same 
statutory and residual grouping as the U.S. gross income that is 
reattributed to the recipient taxable unit. This assignment occurs 
before taking into account any reattribution payments made by the 
recipient taxable unit.
    Foreign gross income included by reason of a remittance is assigned 
to the statutory and residual groupings by reference to the proportion 
of the tax book value of the assets of the remitting taxable unit in 
the groupings as assigned for purposes of apportioning interest 
expense. Sec.  1.861-20(d)(3)(v)(C)(1)(i). In other words, the 
character of the assets of the remitting taxable unit is a proxy for 
the character of the current and accumulated earnings out of which the 
remittance is made. To more accurately reflect the character of the 
remitting taxable unit's earnings, the reattribution asset rule in 
Sec.  1.861-20(d)(3)(v)(C)(1)(ii) requires that a reattribution of 
income from one taxable unit (payor taxable unit) to another taxable 
unit (recipient taxable unit) result in a concomitant reattribution of 
the tax book value of the assets of the payor taxable unit that 
generated the reattributed income (``reattribution assets'') from the 
payor taxable unit to the recipient taxable unit.
    After further study, the Treasury Department and the IRS have 
concluded that the reattribution asset rule is not needed for 
allocating and apportioning foreign tax on a remittance in the case of 
disregarded property sales, and particularly with respect to 
disregarded sales of inventory property. For example, consider a 
domestic corporation that directly owns two taxable units that are 
disregarded for U.S. Federal income tax purposes: DE1,

[[Page 71273]]

which manufactures inventory property, and DE2, which distributes 
inventory property to unrelated customers. DE1 sells the manufactured 
inventory to DE2 in exchange for a disregarded payment. The disregarded 
payment that DE1 receives for the sale of inventory property to DE2 
becomes a reattribution payment when DE2 on-sells the inventory 
property and generates gain in a transaction that is regarded for U.S. 
tax purposes. Accordingly, gain from the sale of the inventory is 
reattributed from the distributing taxable unit to the manufacturing 
taxable unit, and a portion of the distributing taxable unit's assets 
is reattributed to the manufacturing taxable unit. Although the assets 
of the manufacturing taxable unit contributed to the production of the 
income of both taxable units, the tax book value of the manufacturing 
taxable unit's assets is not reattributed to the distributing taxable 
unit. As a result, the reattribution asset rule, by reattributing 
assets only from the distributor taxable unit to the manufacturing 
taxable unit, does not more accurately balance among the taxable units 
all of the assets that produced the gain from the inventory sale. The 
reattribution of assets instead changes the ratios of the assets 
considered held by the taxable units such that a greater percentage of 
the distributor taxable unit's assets consist of non-inventory assets 
(for example, cash), and a greater percentage of the manufacturing 
taxable unit's assets consist of inventory.
    Accordingly, proposed Sec.  1.861-20(d)(3)(v)(E)(6) retains the 
general definition of reattribution asset but excludes any portion of 
the tax book value of property transferred in a disregarded sale from 
being attributed back to the selling taxable unit. Comments are 
requested on whether similar revisions should be made to the 
reattribution asset rule in situations other than disregarded property 
sales. Comments are further requested on other issues related to the 
allocation and apportionment of foreign income taxes to disregarded 
payments, which may be considered in future guidance projects.

II. Creditability of Foreign Taxes Under Sections 901 and 903

A. In General
    Section 901 allows a credit for foreign income, war profits, and 
excess profits taxes, and section 903 provides that such taxes include 
a tax in lieu of a generally-imposed foreign income, war profits, or 
excess profits tax (collectively, ``foreign income taxes''). Before its 
amendment by the 2022 FTC final regulations, Sec.  1.901-2(a)(1) 
provided that a foreign levy was an income tax if and only if (1) it 
was a tax, and (2) the predominant character of that tax was that of an 
income tax in the U.S. sense. Under former Sec.  1.901-2(a)(3), the 
predominant character of a foreign tax was that of an income tax in the 
U.S. sense if the tax (1) was likely to reach net gain in the normal 
circumstances in which it applied (the ``net gain requirement''), and 
(2) was not a ``soak-up'' tax. To satisfy the net gain requirement, a 
foreign tax needed to meet the realization, gross receipts, and net 
income requirements. See former Sec.  1.901-2(b).
    The 2022 FTC final regulations revised the net gain requirement to 
better align the regulatory tests with principles in the Internal 
Revenue Code (``Code'') for determining the base of a U.S. income tax, 
as well as to simplify and clarify the application of these tests. The 
revisions made by the 2022 FTC final regulations ensure that a foreign 
tax is a creditable net income tax only if the determination of the 
foreign tax base conforms in essential respects to the determination of 
taxable income under the Code. In particular, the 2022 FTC final 
regulations limit the role of the predominant character analysis 
generally required under the prior regulations, which often required 
empirical analysis, in determining whether a foreign tax meets each of 
the net gain requirements. Under the 2022 FTC final regulations, a 
foreign tax satisfies the net gain requirement only if the tax 
satisfies the realization requirement, the gross receipts requirement, 
the cost recovery requirement (formerly the net income requirement), 
and the attribution requirement. In addition, the 2022 FTC final 
regulations provide that the determination of whether a foreign tax 
satisfies each component of the net gain requirement is generally based 
on the terms of the foreign tax law governing the computation of the 
tax base and not based on empirical analysis. Sec.  1.901-2(b)(1). The 
2022 FTC final regulations also maintained the long-standing all-or-
nothing rule; that is, a foreign tax either is or is not a foreign 
income tax, in its entirety, for all persons subject to the foreign 
tax. Sec.  1.901-2(a)(1)(i).
B. Cost Recovery Requirement
1. Application Under 2022 FTC Final Regulations
    Consistent with the net income requirement in former Sec.  1.901-
2(b)(4), the 2022 FTC final regulations require, under the cost 
recovery requirement, that the base of a foreign tax permits the 
recovery of significant costs and expenses attributable, under 
reasonable principles, to the gross receipts included in the tax base. 
Sec.  1.901-2(b)(4)(i)(A). However, to ensure that a foreign tax is a 
foreign income tax only if the foreign tax allows for the recovery of 
costs and expenses in a manner that conforms in essential respects to 
the determination of taxable income under the Code, and to limit the 
empirical analysis that would otherwise be required, the 2022 FTC final 
regulations modified the cost recovery requirement in several respects. 
For example, the 2022 FTC final regulations provide a list of costs and 
expenses that are always treated as significant (costs and expenses 
related to capital expenditures, interest, rents, royalties, wages or 
other payments for services, and research and experimentation). Sec.  
1.901-2(b)(4)(i)(C)(1). Whether other costs and expenses are 
significant continues to be determined under an empirical analysis; 
that is, based on whether, for all taxpayers in the aggregate to which 
the foreign tax applies, the item of cost or expense constitutes a 
significant portion of the taxpayers' total costs and expenses. Id.
    However, the 2022 FTC final regulations also recognized that, 
similar to the United States, foreign countries limit the recovery of 
certain significant costs and expenses. As a result, Sec.  1.901-
2(b)(4)(i)(C)(1) provides that foreign tax law is considered to permit 
the recovery of significant costs and expenses, even if recovery of 
certain significant costs and expenses is disallowed in whole or in 
part, if such disallowance is consistent with any principle underlying 
the disallowances required under the Code (``principles-based 
exception'').
2. Response to the 2022 FTC Final Regulations
    Following the publication of the 2022 FTC final regulations, the 
Treasury Department and the IRS have received a number of questions 
regarding the application of the cost recovery requirement as well as 
requests to modify the requirement. In particular, taxpayers and other 
stakeholders identified a number of foreign tax laws that impose 
disallowances or other limitations on the recovery of costs and 
expenses that are not clearly matched to a principle underlying a 
similar disallowance under the Code, even though, in the view of these 
stakeholders, the foreign tax as a whole is consistent with a net 
income tax in the U.S. sense. Moreover, taxpayers noted that, in some 
instances, it was difficult to determine the principle underlying the 
foreign disallowance

[[Page 71274]]

because of a lack of information from the foreign country.
    The Treasury Department and the IRS agree that, in certain 
instances, the cost recovery requirement should be satisfied even if 
the foreign tax law contains a disallowance or other limitation on the 
recovery of a particular cost or expense that may not reflect a 
specific principle underlying a particular disallowance in the Code. 
The income tax provisions of the Code contain a number of disallowances 
and other limitations on the deductibility of certain costs and 
expenses. In some instances, the principle or principles behind the 
limitation is clear, either because the motivation is articulated in 
legislative history or because it is possible to determine the 
principle from the terms of the limitation itself. However, the 
principles underlying other limitations may be less apparent, making it 
difficult to determine whether a foreign limitation on the 
deductibility of certain costs and expenses is consistent with any 
principle underlying the disallowances under the Code.
    As explained in the preamble to the 2022 FTC final regulations, 
section 901 allows credits for foreign taxes that are income taxes in 
the U.S. sense, and this standard is met if there is substantial 
conformity in the principles used to calculate the foreign tax base and 
the U.S. tax base. Complete conformity between the rules for 
determining the foreign tax base and the U.S. tax base is not required. 
Accordingly, the proposed regulations provide additional guidance for 
evaluating disallowances under foreign tax law that may not mirror the 
expense disallowance rules in the Code, but that nonetheless do not 
prevent the foreign tax from being a tax imposed on net income.
    Proposed Sec.  1.901-2(b)(4)(i) retains the general cost recovery 
requirement under the 2022 FTC final regulations, but provides that the 
relevant foreign tax law need only permit recovery of substantially all 
of each item of significant cost or expense. Consistent with the 
general approach of the 2022 FTC final regulations, whether a foreign 
tax permits recovery of substantially all of each item of significant 
cost or expense is determined based solely on the terms of the foreign 
tax law. Proposed Sec.  1.901-2(b)(4)(i)(C)(1).
    Proposed Sec.  1.901-2(b)(4)(i)(C)(2) provides a safe harbor for 
purposes of applying this requirement. Under the safe harbor, a 
disallowance of a stated portion of an item (or multiple items) of 
significant cost or expense does not prevent a foreign tax from 
satisfying the cost recovery requirement if the portion of the item (or 
items) that is disallowed does not exceed 25 percent. This safe harbor 
also permits the foreign tax law to cap deductions of a single item of 
significant cost or expense or multiple items that relate to a single 
category of per se significant costs and expenses described in proposed 
Sec.  1.901-2(b)(4)(i)(B)(2) so long as the cap, based solely on the 
terms of the foreign tax law, is not less than 15 percent of gross 
receipts, gross income, or a similar measure, or in the case of a cap 
based on a percentage of taxable income, or a similar measure, the cap 
is not less than 30 percent. A foreign law limitation that caps 
deductions of multiple items that relate to different categories of per 
se significant costs and expenses at a stated percentage (for example, 
a cap on the deduction of all interest and royalties, combined, at 15 
percent of gross receipts), or that caps deductions of multiple items 
of significant costs or expense that are significant under proposed 
Sec.  1.901-2(b)(4)(i)(B)(1) at a stated percentage, would not meet the 
safe harbor. The safe harbor is intended to provide additional 
certainty where a foreign tax law disallowance is in the form of a 
stated portion or cap. Taxpayers will not need to identify a 
corresponding principle underlying the disallowances required under the 
Code for foreign tax law disallowances that meet the safe harbor. If 
the foreign tax law contains a disallowance that is not within the safe 
harbor, and that otherwise prevents the recovery of substantially all 
of an item of significant cost or expense, then the limitation would be 
examined under the principles-based exception from the 2022 FTC final 
regulations, retained in proposed Sec.  1.901-2(b)(4)(i)(F)(1), which 
permits more substantial disallowances (including complete 
disallowances) of an item of significant cost or expense that are 
consistent with any principle underlying the disallowances required 
under the Code. The proposed regulations make additional clarifications 
to this rule, to provide that the principle must be reflected in a 
disallowance within the income tax provisions of the Code, and if the 
disallowance addresses a non-tax public policy concern, then such 
concern must be similar to the non-tax public policy concerns reflected 
in the Code. In addition, the proposed regulations remove the example 
of a limit on recovery of interest based upon a measure of taxable 
income from this principles-based exception because such a limitation 
would generally be covered by the safe harbor. See proposed Sec.  
1.901-2(b)(4)(iv)(H) (Example 8). If the foreign law disallowance does 
not meet the safe harbor or otherwise permit recovery of substantially 
all of each item of significant cost or expense, the principles-based 
exception would be relevant for determining whether the foreign tax 
could satisfy the cost recovery requirement.
    Additionally, proposed Sec.  1.901-2(b)(4)(iv)(F) through (J) 
provide new examples illustrating the application of the cost recovery 
requirement. The proposed regulations also reorganize the provisions of 
the cost recovery requirement to accommodate the addition of these new 
provisions, as well as to better reflect the structure of the 
requirement.
C. Attribution Requirement for Royalty Payments
1. Application Under 2022 FTC Final Regulations
    The 2022 FTC final regulations added an attribution requirement in 
Sec.  1.901-2(b)(5) as an element of the net gain requirement to 
require that a foreign tax conform to the concepts of taxing 
jurisdiction reflected in the Code that define an income tax in the 
U.S. sense. The purpose of the attribution requirement is to allow a 
credit for a foreign tax only if the country imposing the tax has 
sufficient nexus to the taxpayer's activities or investment of capital 
that generates the income included in the tax base. This result is 
consistent with the statutory purpose of the foreign tax credit to 
relieve double taxation of income through the United States ceding its 
own taxing rights only where the foreign country has the primary right 
to tax the income.
    With respect to a foreign levy imposed on nonresident taxpayers, 
the attribution requirement limits the scope of gross receipts and 
costs included in the base of a foreign tax to those that satisfy the 
activities-based attribution, source-based attribution, or property-
based attribution tests. Sec.  1.901-2(b)(5)(i). These tests are 
consistent with U.S. income tax principles reflected in the Code's 
provisions that only tax foreign persons' income that is effectively 
connected with a U.S. trade or business or attributable to U.S. real 
property, or that is fixed or determinable annual or periodical (FDAP) 
income sourced in the United States.
    Under the source-based attribution requirement in Sec.  1.901-
2(b)(5)(i)(B), a foreign tax imposed on the nonresident's income on the 
basis of source meets the attribution requirement only if the foreign 
tax law's

[[Page 71275]]

sourcing rules are reasonably similar to the sourcing rules that apply 
for Federal income tax purposes. In the case of gross income arising 
from royalties, Sec.  1.901-2(b)(5)(i)(B)(2) provides that the foreign 
tax law must source royalties based on the place of use of, or the 
right to use, the intangible property, consistent with how the Code 
sources royalty income.
    For foreign taxes imposed in lieu of an income tax, the 2022 FTC 
final regulations also modified the substitution requirement in Sec.  
1.903-1, including by adding an attribution requirement. Under Sec.  
1.903-1(c)(2)(iii), a foreign withholding tax must meet the source-
based attribution requirement in Sec.  1.901-2(b)(5)(i)(B) to qualify 
as a ``covered withholding tax'' that may be creditable as a tax in 
lieu of an income tax. Thus, a withholding tax on a royalty payment is 
creditable only if the foreign tax law sources royalties based upon the 
place of use of, or the right to use, the intangible property, 
consistent with how the Code sources royalty income. The 2022 FTC final 
regulations also maintained the all-or-nothing rule for the 
substitution requirement; that is, 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 foreign tax. Sec.  1.903-1(b)(1). Accordingly, a withholding tax 
on royalties that is imposed on the basis of the residence of the payor 
of the royalty is not creditable, whether or not the relevant 
intangible property is in fact used within the territory of the taxing 
jurisdiction. Sec.  1.903-1(d)(3) and (4) (Examples 3 and 4).
    The determination of whether a foreign levy meets the requirements 
under Sec. Sec.  1.901-2 and 1.903-1 is made on a levy-by-levy basis. 
Section 1.901-2(d) provides rules for determining whether one foreign 
levy is separate from another foreign levy. In general, Sec.  1.901-
2(d)(1)(ii) provides that separate levies are imposed on particular 
classes of taxpayers if the tax base is different for those taxpayers. 
The 2022 FTC final regulations added a special rule for withholding 
taxes imposed on nonresidents that treats each such tax as a separate 
levy with respect to each class of gross income (as listed in section 
61) to which the tax applies. Sec.  1.901-2(d)(1)(iii). This rule 
allows withholding taxes that are imposed on classes of income that are 
subject to different sourcing rules of the taxing jurisdiction to be 
analyzed as separate levies under the covered withholding tax 
requirement in Sec.  1.903-1(c)(2). The 2022 FTC final regulations also 
provided that if a foreign country imposes a withholding tax on two or 
more subsets of a separate class of income and a different source rule 
applies to each subset of income, then separate levies are considered 
imposed on each subset of that separate class of income. Sec.  1.901-
2(d)(1)(iii). These special rules reflect the general principle in 
Sec.  1.901-2(d)(1) that the separate levy determination is based upon 
U.S. principles and not whether foreign tax law imposes the levy or 
levies pursuant to a single or separate statutes. The rules also enable 
testing the creditability of a withholding tax on a more granular 
basis. This approach better reflects the purpose of the attribution 
requirement to allow a foreign tax credit only where, in the U.S. view, 
the taxing jurisdiction has the primary right to tax the income.
2. Response to the 2022 FTC Final Regulations
    Following the publication of the 2022 FTC final regulations, the 
Treasury Department and the IRS received questions regarding the 
application of the source-based attribution requirement to certain 
royalty withholding taxes. In addition, the Treasury Department and the 
IRS received requests (including a petition for rulemaking) to change 
the requirement, by allowing a credit even if a foreign country sources 
royalties based on the residence of the payor or by applying a 
different standard.\1\
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    \1\ The Treasury Department and the IRS received a petition for 
rulemaking with respect to the attribution requirement as applied to 
a tax on a resident but declined to engage in rulemaking on that 
subject. The Treasury Department and the IRS have determined that 
the attribution requirement as contained in the 2022 FTC final 
regulations, including as applied to residents, is appropriate to 
ensure that a foreign tax is consistent with the general principles 
of income taxation reflected in the Code. These principles include 
not only those related to determining realization, gross receipts, 
and cost recovery, but also principles for determining the scope of 
the items of gross receipts and costs that may be properly taken 
into account in computing the tax base on which the foreign tax is 
imposed.
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    As an initial matter, some taxpayers questioned whether the 
sourcing rule for royalties was applied differently than that for 
services because Sec.  1.901-2(b)(5)(i)(B)(1) includes a reference to 
the use of ``reasonable principles'' for purposes of applying the 
source-based attribution requirement to a payment for services, while 
the equivalent rule in Sec.  1.901-2(b)(5)(i)(B)(2) for royalties does 
not. Since the introductory text in Sec.  1.901-2(b)(5)(i)(B) states 
that, in all instances, sourcing rules must be reasonably similar to 
the sourcing rules under the Code, the same standard applies regardless 
of whether the relevant payment is for services or for royalties. 
However, to avoid further confusion, the proposed regulations conform 
the language of Sec.  1.901-2(b)(5)(i)(B)(1) and (2).
    Additionally, the Treasury Department and the IRS are aware that, 
in some cases, a taxpayer may license intangible property for use 
solely within the foreign country in which the licensee is resident, 
but the foreign country sources royalties based on the residence of the 
payor. In these cases, notwithstanding the actual use of the licensed 
property in the taxing jurisdiction, a credit would not be allowed for 
the royalty withholding tax under the source-based attribution 
requirement for royalties in Sec.  1.901-2(b)(5)(i)(B). However, in 
these cases, the foreign country imposing tax on the royalty income 
should, from a U.S. perspective, have the primary taxing right over the 
royalty income because the intangible property giving rise to the 
royalty is in fact being used solely in that foreign country. That is, 
notwithstanding the difference in sourcing rules for royalty income, 
there is complete overlap between the jurisdiction with the primary 
right to tax based on U.S. tax principles and the taxing rights 
exercised by the taxing jurisdiction.
    The Treasury Department and the IRS have concluded that it is 
appropriate to provide a limited exception to the source-based 
attribution requirement of the 2022 FTC final regulations where the 
taxpayer can substantiate that a withholding tax is imposed on 
royalties received in exchange for the right to use intangible property 
solely within the territory of the taxing jurisdiction. The Treasury 
Department and the IRS have concluded that it would be unduly 
burdensome for both the taxpayer and the IRS to determine the place of 
use of all intangible property on a country-by-country basis based on 
each taxpayer's facts and circumstances. While taxpayers may need to 
determine the place of use of certain intangible property to determine 
whether the royalty income is U.S. or foreign source, or for other 
purposes, those determinations generally do not require taxpayers or 
the IRS to separately determine the use in a specific foreign country. 
For this reason, this limited exception applies only if the taxpayer 
has a written license agreement that provides for the payment of the 
royalty and that limits the use of the intangible property giving rise 
to the royalty payment to the territory of the foreign country imposing 
the tax.

[[Page 71276]]

3. The Single-Country Exception
    Reflecting this new limited exception, proposed Sec.  1.903-
1(c)(2)(iii) provides that a tested foreign tax satisfies the source-
based attribution requirement if the tax meets either the source-based 
attribution requirement in Sec.  1.901-2(b)(5)(i)(B) or the exception 
in proposed Sec.  1.903-1(c)(2)(iii)(B) (the ``single-country 
exception'').
    In general, the single-country exception applies where (1) the 
income subject to the tested foreign tax is characterized as gross 
royalty income, and (2) the payment giving rise to such income is made 
pursuant to a single-country license. Proposed Sec.  1.903-
1(c)(2)(iii)(B). Consistent with Sec.  1.901-2(b)(5)(i)(B), proposed 
Sec.  1.903-1(c)(2)(iii)(B) provides that foreign tax law generally 
applies for purposes of determining whether the gross income or gross 
receipts arising from a transaction are characterized as a royalty, 
except in the case of a transaction that is considered the sale of a 
copyrighted article under Sec.  1.861-18, which is not treated as a 
license of intangible property but as a sale of tangible property.
    A payment is made pursuant to a single-country license if the terms 
of the written license agreement under which the payment is made 
characterize the payment as a royalty and limit the territory of the 
license to the foreign country imposing the tested foreign tax. 
Proposed Sec.  1.903-1(c)(2)(iv)(A). However, a payment (or portion of 
a payment) may be treated as made pursuant to a single-country license 
even if the written agreement does not limit the territory of the 
license to the foreign country imposing the tax or provides for 
payments in addition to those for the use of intangible property (for 
example, for related services), if the agreement separately states the 
portion (whether as a specified amount or as a formula) of the payment 
subject to the tested foreign tax that is characterized as a royalty 
and that is with respect to the part of the territory of the license 
that is solely within the foreign country imposing the tax. See 
proposed Sec. Sec.  1.903-1(c)(2)(iv)(B) and (d)(9) (Example 9).
    The Treasury Department and the IRS are aware that, to qualify for 
the single-country exception, taxpayers may need to revise existing 
license agreements. Additionally, because certain withholding taxes may 
remain non-creditable, taxpayers may be incentivized to maximize the 
portion of a payment that is made pursuant to a single-country license. 
For example, a taxpayer that receives royalty payments pursuant to a 
related-party license agreement that grants the licensee rights to 
several different types of intangible property--some of which will be 
exploited solely within the taxing jurisdiction and some outside of the 
taxing jurisdiction--may be incentivized to amend the related-party 
license agreement to separately state a royalty amount that purports to 
qualify for the single-country exception but that may exceed an amount 
that, under the arm's length principles of section 482 and sourcing 
principles of section 861, is attributable to the exploitation of the 
intangible property within the taxing jurisdiction. Additionally, 
taxpayers may be disincentivized from revising existing agreements to 
reflect changes in facts and circumstances if doing so would decrease 
the amount of the royalty that is eligible for the single-country 
exception.
    To address these concerns, proposed Sec.  1.903-1(c)(2)(iv)(C) 
provides that a payment is treated as not made pursuant to a single-
country license if the taxpayer knows, or has reason to know, that the 
required agreement misstates the territory in which the intangible 
property is used or overstates the amount of the royalty with respect 
to the part of the territory of the license that is solely within the 
foreign country imposing the tax. Thus, the required agreement must 
reflect the relevant facts and circumstances, as known by the taxpayer 
or as would be known by a reasonably prudent person in the position of 
the taxpayer, regarding both the amount of the relevant royalty and the 
territory in which the intellectual property is actually used.
    In general, a taxpayer cannot qualify for the single-country 
exception without satisfying the documentation requirement in proposed 
Sec.  1.903-1(c)(2)(iv)(D). Under proposed Sec.  1.903-1(c)(2)(iv)(D), 
the required agreement pursuant to which the qualifying royalty is paid 
must be executed no later than the date on which the royalty is paid. 
However, recognizing that the single-country exception is proposed to 
be applicable to periods preceding the release of this notice of 
proposed rulemaking, a special transition documentation rule is 
provided for royalties paid on or before May 17, 2023. In that case, to 
satisfy the documentation requirement, the required agreement must be 
executed no later than May 17, 2023, and the agreement must state 
(whether in the terms of the agreement or in recitals) that royalties 
paid on or before the execution of the agreement are considered paid 
pursuant to the terms of the agreement.
    The required agreement must be maintained by the taxpayer and 
provided to the IRS within 30 days of a request by the Commissioner or 
another period as agreed between the Commissioner and the taxpayer. Id. 
For purposes of the rule, the term taxpayer includes a partnership upon 
which foreign law imposes a tax. See Sec.  1.901-2(f)(4) and (g)(7). 
Therefore, if the royalty withholding tax is imposed at the partnership 
level, the documentation required by the proposed regulations must be 
maintained by the partnership, even though the party that claims the 
credit is the partner and not the partnership. The Treasury Department 
and the IRS request comments as to whether special rules may be 
necessary to address the documentation requirement in the case of 
partnerships.
    Finally, proposed Sec.  1.903-1(d)(3) and (8) through (11) provide 
new examples illustrating the application of the source-based 
attribution rule and single-country exception for covered withholding 
taxes on royalties.
4. Separate Levy
    The proposed regulations also modify the separate levy rule in 
Sec.  1.901-2(d)(1)(iii) for withholding taxes imposed on nonresidents. 
Specifically, Sec.  1.901-2(d)(1)(iii)(B)(3) provides that a 
withholding tax that is imposed on a royalty payment made to a 
nonresident pursuant to a single-country license is treated as a 
separate levy from a withholding tax that is imposed on other royalty 
payments made to such nonresident and from any other withholding taxes 
imposed on other nonresidents. As with the special separate levy rule 
for withholding taxes on different classes of income or different 
subsets of income within a class of income, this rule may result in a 
foreign withholding tax being considered a separate levy in cases where 
the foreign tax law considers only a single levy to be imposed. In 
contrast to a net income tax, this separate levy rule can be applied to 
withholding taxes because withholding taxes on royalties are imposed on 
gross income and on a payment-by-payment basis. In addition, as with 
the other special levy rules, this separate levy rule better aligns the 
outcomes of the test with the purposes of the foreign tax credit rules, 
including that of the attribution requirement. The proposed regulations 
also reorder and reorganize the paragraphs of proposed Sec.  1.901-
2(d)(1)(iii) to accommodate the addition of this new provision, and to 
reflect the structure of the rules more logically.

[[Page 71277]]

III. Applicability Dates

    In general, except for proposed Sec.  1.861-20(d)(3)(v)(E)(6), the 
proposed regulations are proposed to apply to taxable years ending on 
or after November 18, 2022. However, once the proposed regulations are 
finalized, taxpayers may choose to apply some or all of the final 
regulations to earlier taxable years, subject to certain conditions.
    Proposed Sec.  1.861-20(d)(3)(v)(E)(6) is proposed to apply to 
taxable years ending on or after the date final regulations adopting 
these rules are filed with the Federal Register. Taxpayers may choose 
to apply the rules of Sec.  1.861-20(d)(3)(v)(E)(6), once finalized, to 
taxable years that begin after December 31, 2019, and end before the 
date final regulations adopting these rules are filed with the Federal 
Register provided they apply Sec.  1.861-20(d)(3)(v)(E)(6) consistently 
to their first taxable year beginning after December 31, 2019, and any 
subsequent taxable year ending before the date final regulations 
adopting these rules are filed with the Federal Register.
    Proposed Sec.  1.901-2(b)(4)(i) and (iv), (b)(5)(i)(B)(2), and 
(d)(1)(iii) and proposed Sec.  1.903-1(c)(2) and (d)(3), (4), and (8) 
through (11) are proposed to apply to foreign taxes paid in taxable 
years ending on or after November 18, 2022. Taxpayers may choose to 
apply the rules of Sec.  1.901-2(b)(4)(i) and (iv), once finalized, for 
foreign taxes paid in taxable years beginning on or after December 28, 
2021, and ending before November 18, 2022, provided that they 
consistently apply those rules to such taxable years. Taxpayers may 
also choose to apply the rules of Sec. Sec.  1.901-2(b)(5)(i)(B)(2) and 
(d)(1)(iii) and 1.903-1(c)(2) and (d)(3), (4), and (8) through (11), 
once finalized, for foreign taxes paid in taxable years beginning on or 
after December 28, 2021, and ending before November 18, 2022, provided 
that they consistently apply those rules for such taxable years.
    Finally, until the effective date of final regulations, a taxpayer 
may rely on all or part of the proposed regulations, subject to certain 
conditions. Specifically, a taxpayer may choose to rely on the 
provisions addressing the reattribution asset rule (proposed Sec.  
1.861-20(d)(3)(v)(E)(6)) for taxable years that begin after December 
31, 2019, and end before the effective date of final regulations 
adopting these rules. A taxpayer may also choose to rely on the 
provisions addressing the cost recovery requirement (proposed Sec.  
1.901-2(b)(4)(i) and (iv)) for foreign taxes paid in taxable years 
beginning on or after December 28, 2021, and ending before the 
effective date of final regulations adopting these rules. Finally, a 
taxpayer may choose to rely on the provisions addressing the 
attribution requirement for royalty payments (proposed Sec.  1.901-
2(b)(5)(i)(B)(2) and (d)(1)(iii) and proposed Sec.  1.903-1(c)(2) and 
(d)(3), (4), and (8) through (11)) for foreign taxes paid in taxable 
years beginning on or after December 28, 2021, and ending before the 
effective date of final regulations adopting these rules.
    If a taxpayer chooses to rely on any of the three portions of the 
proposed regulations described in the preceding paragraph, the taxpayer 
and its related parties, within the meaning of sections 267(b) 
(determined without regard to section 267(c)(3)) and 707(b)(1), must 
consistently follow all proposed regulations with respect to that 
portion for all relevant years until the effective date of the final 
regulations adopting the rules.

Conforming Amendments to Other Regulations and Guidance

    The Treasury Department and the IRS intend to make conforming 
amendments to other regulations, including the cost recovery rules that 
are not being revised in these proposed regulations and the examples in 
Sec. Sec.  1.901-2(b)(4)(iv) and 1.903-1(d), upon finalization of the 
proposed regulations.

Special Analyses

I. Regulatory Planning and Review

    The Administrator of the Office of Information and Regulatory 
Affairs (``OIRA''), Office of Management and Budget, has determined 
that this proposed rule is not a significant regulatory action, as that 
term is defined in section 3(f) of Executive Order 12866. Therefore, 
OIRA has not reviewed this proposed rule pursuant to section 6(a)(3)(A) 
of Executive Order 12866 and the April 11, 2018, Memorandum of 
Agreement between the Treasury Department and the Office of Management 
and Budget (``OMB'').

II. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3520) (``PRA'') 
requires that a federal agency obtain the approval of the OMB before 
collecting information from the public, whether such collection of 
information is mandatory, voluntary, or required to obtain or retain a 
benefit.
A. Overview
    The collection of information in these proposed regulations is in 
proposed Sec.  1.903-1(c)(2)(iv)(D). As discussed in part II.C.3 of the 
Explanation of Provisions, proposed Sec.  1.903-1(c)(2)(iii)(B) 
provides an exception (the ``single-country exception'') to the source-
based attribution requirement if a taxpayer can substantiate that the 
payment on which the royalty withholding tax is imposed was made 
pursuant to an agreement that limits the right to use intangible 
property to the jurisdiction imposing the tested foreign tax. Proposed 
Sec.  1.903-1(c)(2)(iv)(A). The exception applies only where the 
taxpayer has a written license agreement that provides for the payment 
of the royalty and that limits the use of the intangible property 
giving rise to the royalty payment to the territory of the foreign 
country imposing the tax. A payment may also qualify for the single-
country exception if the agreement separately states the portion 
(whether as a specified amount or as a formula) of the payment subject 
to the tested foreign tax that is characterized as a royalty and that 
is with respect to the portion of the territory of the license that is 
solely within the foreign country imposing the tax. Proposed Sec.  
1.903-1(c)(2)(iv)(B).
    Proposed Sec.  1.903-1(c)(2)(iv)(D) requires taxpayers who claim 
eligibility for the exception to provide an agreement described in 
proposed Sec.  1.903-1(c)(2)(iv)(A) or (B), as applicable, (the 
``required agreement'') within 30 days of a request by the Commissioner 
or another period as agreed between the Commissioner and the taxpayer. 
Proposed Sec.  1.903-1(c)(2)(iv)(D) also provides a transition rule in 
the case of a royalty paid on or before May 17, 2023, that requires the 
required agreement to be executed no later than May 17, 2023.
B. Collection of Information--Proposed Sec.  1.903-1(c)(2)(iv)(D)
    The Treasury Department and the IRS intend that the information 
collection requirement in proposed Sec.  1.903-1(c)(2)(iv)(D) will be 
set forth in the forms and instructions identified in Table 1.

[[Page 71278]]



                       Table 1--Tax Forms Impacted
------------------------------------------------------------------------
                                    Number of       Forms to which the
   Collection of information       respondents      information may be
                                   (estimated)           attached
------------------------------------------------------------------------
Proposed Sec.   1.903-               \2\ 42,030  Form 1116 and Form
 1(c)(2)(iv)(D).                                  1118.
------------------------------------------------------------------------
Source: IRS's Compliance Data Warehouse.

    The estimate for the number of impacted filers with respect to the 
collection of information in proposed Sec.  1.903-1(c)(2)(iv)(D) is 
based on the number of U.S. corporations that filed a return that had a 
Form 1118 that reported an amount of withholding tax on rents, 
royalties, and license fees on Schedule B, Part I, column e; U.S. 
corporations that filed a return that had a Form 1118 that reported an 
amount of deemed paid taxes and a Form 5471 that reported an amount of 
gross royalties and license fees on Schedule C (and thus may have 
incurred a withholding tax on those royalties); and U.S. individuals 
that filed a return and had a Form 1116 that reported an amount of 
withholding tax on rents and royalties on Part II, column n.\3\ This 
represents an upper bound of potentially affected taxpayers: not all 
taxpayers that have reported an amount of royalty withholding tax paid 
to a foreign country or that have royalty income on which they may have 
paid a withholding tax are expected to claim a credit for such tax, and 
not all taxpayers who claim such a credit are expected to rely on the 
single country exception in proposed Sec.  1.903-1(c)(2)(iii)(B).
---------------------------------------------------------------------------

    \2\ The estimated number of respondents in this Table 1 is based 
on the number of respondents from the 2020 tax year.
    \3\ As explained in part II.C.3 of the Explanation of 
Provisions, the collection of information in proposed Sec.  1.903-
1(c)(2)(iv)(D) also impacts partnerships and S corporations that pay 
a withholding tax that is imposed at the partnership or S 
corporation level under foreign law even though it is the partners 
or S corporation shareholder that claims the credit for those taxes. 
The Treasury Department and the IRS lack sufficient data to identify 
the number of partnerships and S corporations that pay foreign 
withholding taxes on royalty income. However, the IRS and Treasury 
Department do not expect that this will impact the number of 
affected taxpayers since the partners and shareholders that claim a 
credit for the royalty withholding tax would be captured within the 
Form 1116 and Form 1118 filers.
---------------------------------------------------------------------------

    The Treasury Department and the IRS expect that taxpayers subject 
to the collection of information in proposed Sec.  1.903-1(c)(2)(iv)(D) 
will not have a significant increase in burden (if any) because some 
taxpayers may already have existing license agreements that qualify for 
the single-country exception in place for a variety of tax and non-tax 
law reasons, and other taxpayers may not elect to take advantage of the 
single-country exception. The reporting burden associated with this 
collection of information will be reflected in future PRA submissions 
associated with Form 1118 (OMB control number 1545-0123), Form 1065 
(OMB control number 1545-0123), and Form 1116 (OMB control numbers 
1545-0074 for individuals, and 1545-0121 for estates and trusts). The 
collection of information in proposed Sec.  1.903-1(c)(2)(iv)(D) will 
be reflected in future Paperwork Reduction Act submissions that the 
Treasury Department and the IRS will submit to OMB for these forms. The 
current status of the Paperwork Reduction Act submissions related to 
these forms is summarized in Table 2.
    Because the proposed regulations, including the collection of 
information in proposed Sec.  1.903-1(c)(2)(iv)(D), are proposed to 
apply to taxes paid in taxable years ending on or after the date the 
proposed regulations are filed with the Federal Register, the Treasury 
Department and the IRS have submitted the collection of information in 
proposed Sec.  1.903-1(c)(2)(iv)(D) to the OMB for review in accordance 
with the Paperwork Reduction Act and requested a new OMB control number 
(the ``temporary OMB control number''). After the rulemaking is 
finalized, the information collection contained within the regulations 
will be incorporated into the OMB control numbers described in Table 2.

                           Table 2--Status of Current Paperwork Reduction Submissions
----------------------------------------------------------------------------------------------------------------
                                                                                               Incorporated into
                                                                             Temporary OMB    OMB control No.(s)
                   Form                             Type of filer             control No.         after final
                                                                                                  rulemaking
----------------------------------------------------------------------------------------------------------------
Form 1116.................................  Trusts & estates............            1545-NEW           1545-0121
                                            Individual..................            1545-NEW           1545-0074
Form 1118.................................  Business....................            1545-NEW           1545-0123
----------------------------------------------------------------------------------------------------------------

    Commenters are strongly encouraged to submit public comments 
electronically. Comments and recommendations for the proposed 
information collection should be sent to https://www.reginfo.gov/public/do/PRAMain, with electronic copies emailed to the IRS at 
[email protected] (indicate REG-112096-22 on the subject line). This 
particular information collection can be found by selecting ``Currently 
under Review--Open for Public Comments'' then by using the search 
function. Comments can also be mailed to OMB, Attn: Desk Officer for 
the Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies mailed to the IRS, Attn: IRS 
Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. 
Comments on the collections of information should be received by 
January 23, 2023.
    The likely respondents associated with the temporary OMB control 
number are U.S. persons who pay or accrue foreign withholding taxes on 
royalty income.
    Estimated total annual reporting burden: 420,300 hours.
    Estimated average annual burden per respondent: 10 hours.
    Estimated number of respondents: 42,030.
    Estimated frequency of responses: Annually.
    The Treasury Department and the IRS expect to add the burden for 
this

[[Page 71279]]

temporary OMB control number to OMB control numbers 1545-0123, 1545-
0074, and 1545-0121 after the final rulemaking. For 1545-0123 and 1545-
0074, the Treasury Department and the IRS estimate burdens on a 
taxpayer-type basis rather than a provision-specific basis.

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that the proposed regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act.
    The proposed regulations provide guidance affecting individuals and 
corporations claiming foreign tax credits. The domestic small business 
entities that are subject to the foreign tax credit rules in the Code 
and in the proposed regulations are generally those that operate in a 
foreign country or that have income from sources outside of the United 
States and pay foreign taxes. The reattribution asset definition in 
proposed Sec.  1.861-20(d)(3)(v)(E)(6) applies only to taxable units 
that make or receive disregarded payments that are considered 
reattribution payments which result in the reattribution of assets from 
one taxable unit to another. Sec.  1.861-20(d)(3)(v)(C)(1)(ii). In 
addition, some provisions of these proposed regulations, such as 
proposed Sec.  1.903-1, apply only to entities that license 
intellectual property for use in a foreign country and receive royalty 
payments that are subject to foreign withholding tax. The Treasury 
Department and the IRS do not expect that the proposed regulations will 
likely affect a substantial number of domestic small business entities 
because it is infrequent for domestic small entities to engage in 
significant foreign operations or in the types of transactions giving 
rise to the foreign taxes addressed by these proposed regulations. 
However, the Treasury Department and the IRS do not have adequate data 
readily available to assess the number of small entities potentially 
affected by the final regulations.
    The Treasury Department and the IRS have determined that the 
proposed regulations will not have a significant economic impact on 
domestic small business entities. To provide an upper bound estimate of 
the impact these final regulations could have on business entities, the 
Treasury Department and the IRS calculated, based on e-file data for 
the 2020 tax year, foreign tax credits as a percentage of four 
different tax-related measures of annual receipts (see Table 3 for 
variables) by corporations. As demonstrated by the data in Table 3 
below, foreign tax credits as a percentage of all four measures of 
annual receipts are substantially less than the three to five percent 
threshold for significant economic impact for corporations with 
business receipts less than $250 million.

                                                     Table 3--FTCs as Percentage of Annual Receipts
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                    Under     $500k to    $1M to     $5M to    $10M to    $50M to    $100M to   $250M or
                   Size (by business receipts)                      $500k       $1M        $5M        $10M       $50M      $100M      $250M       more
--------------------------------------------------------------------------------------------------------------------------------------------------------
FTC/Gross Receipts (%)..........................................       0.00       0.00       0.00       0.01       0.01       0.02       0.03       0.05
FTC/Business Receipts (%).......................................       0.00       0.00       0.00       0.00       0.01       0.02       0.03       0.05
FTC/Total Income (%)............................................       0.00       0.00       0.00       0.01       0.02       0.04       0.07       0.57
FTC/(Total Income--Total Deductions) (%)........................      -0.02       0.03       0.05       0.11       0.16       0.41       0.72       3.33
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: RAAS:KDA (Tax Year 2020 CDW E-File Data 9-26-22).
Note: Business Receipts = Total Income + Cost of Goods Sold.

    The Treasury Department and the IRS anticipate that only a small 
fraction of existing foreign tax credits would be impacted by these 
regulations, and thus, the economic impact of these regulations will be 
considerably smaller than the effects shown in Table 3. A portion of 
economic impact of these proposed regulations derive from the 
collection of information requirement in proposed Sec.  1.903-
1(c)(2)(iv)(D). The Treasury Department and the IRS do not have readily 
available data to determine the incremental burden that this collection 
of information will have on small business entities. However, the 
Treasury Department and the IRS believe this collection of information 
will only marginally increase taxpayers' burdens because some taxpayers 
may already have existing license agreements that qualify for the 
single-country exception for a variety of tax and non-tax law reasons, 
and other taxpayers may not elect to take advantage of the single-
country exception. Furthermore, as demonstrated in Table 3 in this Part 
III of the Special Analyses, foreign tax credits do not have a 
significant economic impact for any gross-receipts class of business 
entities. Therefore, proposed Sec.  1.903-1(c)(2)(iv)(D) will not have 
a significant economic impact on small business entities. Accordingly, 
it is hereby certified that the proposed regulations will not have a 
significant economic impact on a substantial number of small entities.

IV. Section 7805(f)

    Pursuant to section 7805(f), these proposed regulations will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small businesses. The 
Treasury Department and the IRS also request comments from the public 
on the certifications in this Part III of the Special Analyses.

V. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) 
requires that agencies assess anticipated costs and benefits and take 
certain other actions before issuing a final rule that includes any 
Federal mandate that may result in expenditures in any one year by a 
state, local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. This proposed rule does not include any Federal mandate that 
may result in expenditures by state, local, or tribal governments, or 
by the private sector in excess of that threshold.

VI. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on State and local 
governments, and is not required by statute, or preempts State law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive order. This proposed rule does not have 
federalism implications and does not impose substantial direct 
compliance costs on state and local governments or preempt State law 
within the meaning of the Executive order.

[[Page 71280]]

Comments and Request for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ADDRESSES heading. 
The Treasury Department and the IRS request comments on all aspects of 
the proposed rules, and specifically on the issues identified in Parts 
I.B and II.C.3 of the Explanation of Provisions. All comments will be 
available at www.regulations.gov or upon request.
    A public hearing will be scheduled if requested in writing by any 
person that timely submits written comments. Requests for a public 
hearing are encouraged to be made electronically. If a public hearing 
is scheduled, notice of the date and time for the public hearing will 
be published in the Federal Register. Announcement 2020-4, 2020-17 IRB 
1, provides that until further notice, public hearings conducted by the 
IRS will be held telephonically. Any telephonic hearing will be made 
accessible to people with disabilities.

Drafting Information

    The principal authors of the proposed regulations are Jeffrey L. 
Parry, Teisha M. Ruggiero, and Suzanne M. Walsh of the Office of 
Associate Chief Counsel (International). However, other personnel from 
the Treasury Department and the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, the Treasury Department and IRS propose to amend 26 
CFR part 1 as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

0
Par. 2. Section 1.861-20 is amended by revising paragraphs 
(d)(3)(v)(E)(6) and (i) to read as follows:


Sec.  1.861-20  Allocation and apportionment of foreign income taxes.

* * * * *
    (d) * * *
    (3) * * *
    (v) * * *
    (E) * * *
    (6) Reattribution asset. The term reattribution asset means an 
asset that produces one or more items of gross income, computed under 
Federal income tax law, to which a disregarded payment, other than a 
disregarded payment received in exchange for property, is allocated 
under the rules of paragraph (d)(3)(v)(B)(2) of this section.
* * * * *
    (i) Applicability dates. (1) Except as provided in paragraphs 
(i)(2) through (4) of this section, this section applies to taxable 
years beginning after December 31, 2019.
    (2) Paragraphs (b)(19) and (23) and (d)(3)(i), (ii), and (v) of 
this section apply to taxable years that begin after December 31, 2019, 
and end on or after November 2, 2020.
    (3) Paragraph (d)(3)(v)(E)(6) of this section applies to taxable 
years that end on or after [date the final rule is filed with the 
Federal Register]. Taxpayers may choose to apply the rules in paragraph 
(d)(3)(v)(E)(6) of this section to taxable years beginning after 
December 31, 2019, and ending before [date the final rule is filed with 
the Federal Register], provided they apply paragraph (d)(3)(v)(E)(6) of 
this section consistently to their first taxable year beginning after 
December 31, 2019, and any subsequent taxable year beginning before 
[date the final rule is filed with the Federal Register]. Otherwise, 
for taxable years beginning after December 31, 2019, and ending before 
[date the final rule is filed with the Federal Register], see Sec.  
1.861-20(d)(3)(v)(E)(6) as contained in 26 CFR part 1 revised as of 
July 27, 2022.
    (4) Paragraph (h) of this section applies to taxable years 
beginning after December 28, 2021.
0
Par 3. Section 1.901-2 is amended:
0
1. By revising paragraph (b)(4)(i)(A).
0
2. By redesignating paragraphs (b)(4)(i)(B), (b)(4)(i)(C)(3), and 
(b)(4)(i)(D) as paragraph (b)(4)(i)(G), (b)(4)(i)(D), and (b)(4)(i)(E), 
respectively.
0
3. By adding new paragraph (b)(4)(i)(B).
0
4. By revising paragraph (b)(4)(i)(C).
0
5. By revising the first sentence of newly redesignated paragraph 
(b)(4)(i)(D).
0
6. By adding paragraph (b)(4)(i)(F).
0
7. In newly redesignated paragraph (b)(4)(i)(G)(1), by removing the 
language ``one or more significant costs and expenses'' and adding the 
language ``substantially all of each item of significant cost or 
expense'' in its place.
0
8. In paragraph (b)(4)(iv)(A)(2), by removing the language 
``significant costs and expenses'' and adding the language 
``substantially all of each item of significant cost or expense'' in 
its place.
0
9. In paragraph (b)(4)(iv)(B)(2), by removing the language 
``(b)(4)(i)(B)(2)'' and adding the language ``(b)(4)(i)(G)(2)'' in its 
place.
0
10. By removing and reserving paragraph (b)(4)(iv)(C).
0
11. In paragraphs (b)(4)(iv)(D)(2) and (b)(4)(iv)(E)(2), by removing 
the language ``(b)(4)(i)(C)(2)'' and adding the language 
``(b)(4)(i)(F)(2)'' in its place.
0
12. By adding paragraphs (b)(4)(iv)(F) through (J).
0
13. By revising paragraphs (b)(5)(i)(B)(2), (d)(1)(iii), and (h).
    The revisions and additions read as follows:


Sec.  1.901-2  Income, war profits, or excess profits tax paid or 
accrued.

* * * * *
    (b) * * *
    (4) * * *
    (i) * * *
    (A) In general. A foreign tax satisfies the cost recovery 
requirement if the base of the tax is computed by reducing gross 
receipts (as described in paragraph (b)(3) of this section) to permit 
recovery of substantially all of each item of significant cost or 
expense (including each item of cost or expense related to the 
categories described in paragraph (b)(4)(i)(B)(2) of this section) 
attributable, under reasonable principles, to such gross receipts. See 
paragraph (b)(4)(i)(B) of this section for rules regarding the 
determination of what is a significant cost or expense, paragraph 
(b)(4)(i)(C) of this section for rules regarding the recovery of 
substantially all of an item, paragraph (b)(4)(i)(E) of this section 
for rules regarding principles for attributing costs and expenses to 
gross receipts, and paragraph (b)(4)(i)(F) of this section for 
exceptions to this rule. A foreign tax need not permit recovery of 
significant costs and expenses, such as certain personal expenses, that 
are not attributable, under reasonable principles, to gross receipts 
included in the foreign tax base. A foreign tax whose base is gross 
receipts, with no reduction for costs and expenses, satisfies the cost 
recovery requirement only if there are no significant costs and 
expenses described in paragraph (b)(4)(i)(B) of this section 
attributable to the gross receipts included in the foreign tax base. 
See paragraph (b)(4)(iv)(A) of this section (Example 1). A foreign tax 
that provides an alternative cost allowance satisfies the cost recovery 
requirement only as provided in paragraph (b)(4)(i)(G) of this section.
    (B) Significant costs and expenses--(1) In general. Except as 
provided in paragraph (b)(4)(i)(B)(2) of this section, whether an item 
of cost or expense is significant for purposes of this paragraph 
(b)(4)(i) is determined based

[[Page 71281]]

on whether, for all taxpayers in the aggregate to which the foreign tax 
applies, the item of cost or expense constitutes a significant portion 
of the taxpayers' total costs and expenses.
    (2) Per se significant costs and expenses. An item of cost or 
expense (as characterized under foreign law) related to capital 
expenditures, interest, rents, royalties, wages or other payments for 
services, and research and experimentation is always treated as an item 
of significant cost or expense for purposes of this paragraph 
(b)(4)(i).
    (C) Recovery of substantially all of each item--(1) In general. 
Whether a foreign tax permits recovery of substantially all of each 
item of significant cost or expense is determined based solely on the 
terms of the foreign tax law.
    (2) Safe harbor. One or more disallowances of a stated portion of 
an item (or multiple items) of significant cost or expense does not 
prevent a foreign tax from being considered to permit recovery of 
substantially all of each item of significant cost or expense if the 
total portion of the item (or items) that is disallowed does not exceed 
25 percent. A limitation that caps the recovery of an item of 
significant cost or expense, or multiple items of cost or expense that 
relate to a single category of significant costs and expenses described 
in paragraph (b)(4)(i)(B)(2) of this section does not prevent a foreign 
tax from being considered to permit recovery of substantially all of 
each item of significant cost or expense if the limitation is a 
qualifying cap. For such purpose, a limitation that caps the recovery 
at a stated portion of gross receipts, gross income, or a similar 
measure is a qualifying cap if the stated portion of such measure is 
not less than 15 percent. A limitation that caps the recovery at a 
stated portion of taxable income (determined without regard to the item 
at issue) or a similar measure is a qualifying cap if the stated 
portion of such measure is not less than 30 percent.
    (3) Non-recovery of significant costs and expenses. Significant 
costs and expenses (such as interest expense) are not considered to be 
recovered by reason of the time value of money attributable to the 
acceleration of a tax benefit or economic benefit attributable to the 
timing of the recovery of other costs and expenses (such as the current 
expensing of debt-financed capital expenditures).
    (D) * * * A foreign tax law permits recovery of substantially all 
of each item of significant cost or expense even if such item of cost 
or expense is recovered earlier or later than it is recovered under the 
Internal Revenue Code unless the time of recovery is so much later as 
effectively to constitute a denial of such recovery. * * *
* * * * *
    (F) Exceptions--(1) Disallowances consistent with U.S. principles. 
Notwithstanding paragraph (b)(4)(i)(A) of this section, a disallowance 
of all or a portion of an item of significant cost or expense does not 
prevent a foreign tax from satisfying the cost recovery requirement if 
such disallowance is consistent with any principle underlying the 
disallowances required under the income tax provisions of the Internal 
Revenue Code, including the principles of limiting base erosion or 
profit shifting and addressing non-tax public policy concerns similar 
to those reflected in the Internal Revenue Code. For example, a foreign 
tax may satisfy the cost recovery requirement even if the foreign tax 
law disallows deductions in connection with hybrid transactions, 
disallows deductions attributable to gross receipts that in whole or in 
part are excluded, exempt or eliminated from taxable income, or 
disallows certain deductions consistent with non-tax public policy 
considerations similar to those underlying the disallowances contained 
in section 162. See paragraphs (b)(4)(iv)(I) and (J) of this section 
(Examples 9 and 10).
    (2) Amounts that need not be recovered. A foreign tax law may 
satisfy the cost recovery requirement even if the foreign tax law does 
not permit recovery of costs and expenses attributable to wage income 
or to investment income that is not derived from a trade or business. 
In addition, in determining whether a foreign tax (the ``tested foreign 
tax'') meets the cost recovery requirement, it is immaterial whether 
the tested foreign tax allows a deduction for other taxes that would 
qualify as foreign income taxes (determined without regard to whether 
such other tax allows a deduction for the tested foreign tax). See 
paragraphs (b)(4)(iv)(D) and (E) of this section (Examples 4 and 5).
* * * * *
    (iv) * * *
    (F) Example 6: Substantially all; application of the safe 
harbor--(1) Facts. Country X imposes a tax (``Country X tax'') on 
the income of corporations that are resident in Country X. Under 
Country X tax law, full deductions are allowed for each item of 
significant cost or expense attributable under reasonable principles 
to the gross receipts included in the Country X tax base, except 
that Country X tax law disallows a deduction for 25 percent of a 
taxpayer's costs and expenses for royalties related to patents.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, 
an item of cost or expense related to royalties is always treated as 
a significant cost or expense, and therefore, under paragraph 
(b)(4)(i)(A) of this section, absent an exception, Country X tax law 
must permit recovery of substantially all of each item of cost or 
expense related to royalties, including the item of royalties 
related to patents. The stated percentage of costs and expenses from 
royalties related to patents (25 percent) that is disallowed under 
Country X tax law does not exceed 25 percent. Accordingly, under the 
safe harbor in paragraph (b)(4)(i)(C)(2) of this section, the 
disallowance does not prevent the Country X tax from being 
considered to permit recovery of substantially all of each item of 
cost or expense related to royalties, and therefore the Country X 
tax satisfies the cost recovery requirement.
    (G) Example 7: Substantially all; application of the safe 
harbor--(1) Facts. Country X imposes a tax (``Country X tax'') on 
the income of corporations that are resident in Country X. Under 
Country X tax law, full deductions are allowed for each item of 
significant cost or expense attributable under reasonable principles 
to the gross receipts included in the Country X tax base, except 
that Country X tax law disallows a deduction for 15 percent of a 
taxpayer's costs and expenses for rents and 25 percent of a 
taxpayer's costs and expenses for interest.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, 
an item of cost or expense related to rents or interest is always 
treated as a significant cost or expense, and therefore, under 
paragraph (b)(4)(i)(A) of this section, absent an exception, Country 
X tax law must permit recovery of substantially all of each item of 
cost or expense related to royalties and interest. The stated 
percentage of the costs and expenses related to rents (15 percent) 
that is disallowed under Country X tax law does not exceed 25 
percent. Additionally, the stated percentage of the costs and 
expenses related to interest (25 percent) that is disallowed under 
Country X law does not exceed 25 percent. Accordingly, under the 
safe harbor in paragraph (b)(4)(i)(C)(2) of this section, the 
disallowances do not prevent the Country X tax from being considered 
to permit recovery of substantially all of each item of cost or 
expense related to rents and interest, and therefore the Country X 
tax satisfies the cost recovery requirement.
    (H) Example 8: Substantially all; application of the safe 
harbor--(1) Facts. Country X imposes a tax (``Country X tax'') on 
the income of corporations that are resident in Country X. Under 
Country X tax law, full deductions are allowed for each item of 
significant cost or expense attributable under reasonable principles 
to the gross receipts included in the Country X tax base, except 
that Country X tax law caps the recovery of the deduction of 
interest at 30 percent of the taxpayer's taxable income determined 
without regard to interest expense.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, 
an item of cost or expense related to interest is always

[[Page 71282]]

treated as a significant cost or expense, and therefore, under 
paragraph (b)(4)(i)(A) of this section, absent an exception, Country 
X tax law must permit recovery of substantially all of each item of 
cost or expense related to interest. The stated cap on recovery in 
Country X tax law with respect to interest (30 percent of taxable 
income determined without regard to interest expense) is not less 
than 30 percent of taxable income determined without regard to 
interest expense. Additionally, the cap on recovery relates to a 
single category of significant costs and expenses described in 
paragraph (b)(4)(i)(B)(2) of this section. Accordingly, under the 
safe harbor in paragraph (b)(4)(i)(C)(2) of this section, the 
disallowance does not prevent the Country X tax from being 
considered to permit recovery of substantially all of each item of 
cost or expense related to interest, and therefore the Country X tax 
satisfies the cost recovery requirement.
    (I) Example 9: Permissible disallowance based on U.S. 
principles--(1) Facts. Country X imposes a tax on the income of 
corporations that are resident in Country X. Under Country X tax 
law, full deductions are allowed for each item of significant cost 
or expense attributable under reasonable principles to the gross 
receipts included in the Country X tax base, except that under 
Country X's anti-hybrid rules, a deduction is disallowed for any 
payment, including interest, royalties, rents, or payments for 
services, made by a Country X resident to a related entity located 
outside of Country X if the payment is not included in gross income 
by the payee or the payee is not subject to tax.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, 
each item of cost or expense related to interest, rents, royalties, 
and payments for services is always treated as a significant cost or 
expense, and therefore, under paragraph (b)(4)(i)(A) of this 
section, absent an exception, Country X tax law must permit recovery 
of substantially all of each item of cost or expense related to 
interest, rents, royalties, and payments for services. Country X tax 
law does not permit recovery of any portion of any item of 
significant cost or expense that is subject to the anti-hybrid 
rules. As a result, the safe harbor in paragraph (b)(4)(i)(C)(2) of 
this section does not apply to such item. Further, because a 
deduction is disallowed for any item of cost or expense that is 
subject to the Country X anti-hybrid rules, the Country X tax law 
completely disallows certain items of cost and expense related to 
interest, rents, royalties, and payments for services and thus does 
not permit recovery of substantially all of each item of significant 
cost or expense related to interest, rents, royalties, and payments 
for services. However, under paragraph (b)(4)(i)(F)(1) of this 
section, a disallowance of all or a portion of an item of 
significant cost or expense does not prevent a foreign tax from 
satisfying the cost recovery requirement if the disallowance is 
consistent with any principle underlying the disallowances required 
under the income tax provisions of the Internal Revenue Code. The 
income tax provisions of the Internal Revenue Code, specifically 
section 267A, contain disallowances of deductions based on the 
principle of limiting base erosion or profit shifting. Country X's 
disallowance of deductions for any payment, including interest, 
royalties, rents, or payments for services also reflects the 
principle of limiting base erosion or profit shifting. Accordingly, 
because Country X's anti-hybrid rules are consistent with the 
principle of limiting base erosion or profit shifting, the Country X 
tax satisfies the cost recovery requirement.
    (J) Example 10: Permissible disallowance based on U.S. 
principles--(1) Facts. Country X imposes a tax on the income of 
corporations that are resident in Country X. Under Country X tax 
law, full deductions are allowed for each item of significant cost 
or expense attributable to the gross receipts included in the 
Country X tax base, except that no deduction is permitted for any 
stock-based payments for services.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, 
each item of cost or expense related to wages or other payments for 
services is always treated as a significant cost or expense, and 
therefore, under paragraph (b)(4)(i)(A) of this section, absent an 
exception, Country X tax law must permit recovery of substantially 
all of each item of cost or expense related to wages or other 
payments for services. Country X tax law denies a deduction for any 
stock-based payments for services, and therefore the safe harbor in 
paragraph (b)(4)(i)(C)(2) of this section is not satisfied. Further, 
given that no deduction is allowed for stock-based payments for 
services, the Country X tax law completely disallows an item of cost 
or expense related to wages or other payments for services and thus 
does not permit recovery of substantially all of each item of 
significant cost or expense related to wages or other payments for 
services. However, under paragraph (b)(4)(i)(F)(1) of this section, 
a disallowance of all or a portion of an item of significant cost or 
expense does not prevent a foreign tax from satisfying the cost 
recovery requirement if such disallowance is consistent with any 
principle underlying the disallowances required under the income tax 
provisions of the Internal Revenue Code. The income tax provisions 
of the Internal Revenue Code contain targeted disallowances or 
limits on the deductibility of certain items of compensation in 
particular circumstances based on non-tax public policy reasons, 
including to influence the amount or use of a certain type of 
compensation in the labor market. For example, section 162(m) 
imposes limits on deductions for compensation of certain highly-paid 
employees, and section 280G limits the deductibility of certain 
``parachute payments'' provided to individuals when an entity 
undergoes a change of control. Country X's targeted disallowance of 
deductions for the portion of payments for services attributable to 
stock-based compensation also reflects a principle of influencing 
the amount or use of a certain type of compensation (stock-based 
compensation) in the labor market. Accordingly, because the Country 
X tax law's disallowance is consistent with a principle underlying 
the disallowances required under the income tax provisions of the 
Internal Revenue Code, the Country X tax satisfies the cost recovery 
requirement.
    (5) * * *
    (i) * * *
    (B) * * *

    (2) Royalties. Under the foreign tax law, gross income from 
royalties must be sourced based on the place of use of, or the right to 
use, the intangible property, as determined under reasonable principles 
(which do not include determining the place of use of, or the right to 
use, the intangible property based on the location of the payor).
* * * * *
    (d) * * *
    (1) * * *
    (iii) Tax imposed on nonresidents--(A) In general. A foreign levy 
imposed on nonresidents is always treated as a separate levy from that 
imposed on residents, even if the base of the tax as applied to 
residents and nonresidents is the same, and even if the levies are 
treated as a single levy under foreign tax law.
    (B) Withholding tax--(1) In general. Except as otherwise provided 
in this paragraph (d)(1)(iii)(B), a withholding tax (as defined in 
section 901(k)(1)(B)) that is imposed on a payment giving rise to gross 
income of nonresidents is treated as a separate levy as to each 
separate class of income described in section 61 (for example, 
interest, dividends, rents, or royalties) subject to the withholding 
tax.
    (2) Subsets of income. If two or more subsets of a separate class 
of income are subject to a withholding tax based on different income 
attribution rules (for example, if technical services are subject to 
tax based on the residence of the payor and other services are subject 
to tax based on where the services are performed), separate levies are 
considered to be imposed with respect to each subset of that separate 
class of income.
    (3) Royalty income. A withholding tax that is imposed on a payment 
giving rise to gross royalty income of a nonresident that is made 
pursuant to a single-country license (as determined under Sec.  1.903-
1(c)(2)(iv)) is treated as a separate levy from a withholding tax that 
is imposed on other gross royalty income of such nonresident and is 
also treated as a separate levy from any withholding tax imposed on 
other nonresidents.
* * * * *
    (h) Applicability dates--(1) In general. Except as provided in 
paragraphs (h)(2) and (3) of this section, this section applies to 
foreign taxes paid (within the meaning of paragraph (g) of this 
section) in taxable years beginning on or after December 28, 2021. For 
foreign taxes

[[Page 71283]]

that relate to (and if creditable are considered to accrue in) taxable 
years beginning before December 28, 2021, and that are remitted in 
taxable years beginning on or after December 28, 2021, by a taxpayer 
that accounts for foreign income taxes on the accrual basis, see Sec.  
1.901-2 as contained in 26 CFR part 1 revised as of April 1, 2021.
    (2) Certain foreign taxes paid to Puerto Rico. For foreign taxes 
paid to Puerto Rico by reason of section 1035.05 of the Puerto Rico 
Internal Revenue Code of 2011, as amended (13 L.P.R.A. 30155) (treating 
certain income, gain or loss as effectively connected with the active 
conduct of a trade or business with Puerto Rico), this section applies 
to foreign taxes paid (within the meaning of paragraph (g) of this 
section) in taxable years beginning on or after January 1, 2023. For 
foreign taxes described in the preceding sentence that are paid in 
taxable years beginning before January 1, 2023, see Sec.  1.901-2 as 
contained in 26 CFR part 1 revised as of April 1, 2021.
    (3) Modifications to cost recovery and royalty attribution rules. 
Paragraphs (b)(4)(i) and (iv), (b)(5)(i)(B)(2), and (d)(1)(iii) of this 
section apply to foreign taxes paid (within the meaning of paragraph 
(g) of this section) in taxable years ending on or after November 18, 
2022. For foreign taxes described in the preceding sentence that are 
paid in taxable years ending before November 18, 2022, see Sec.  1.901-
2(b)(4)(i) and (iv), (b)(5)(i)(B)(2), and (d)(1)(iii) as contained in 
26 CFR part 1 revised as of July 27, 2022. Taxpayers may choose to 
apply the rules in paragraphs (b)(4)(i) and (iv) of this section to 
foreign taxes paid in taxable years beginning on or after December 28, 
2021, and ending before November 18, 2022 provided that they 
consistently apply those rules to such taxable years. Additionally, 
taxpayers may choose to apply the rules of paragraphs (b)(5)(i)(B)(2) 
and (d)(1)(iii) of this section to foreign taxes paid in taxable years 
beginning on or after December 28, 2021, and ending before November 18, 
2022, provided that they consistently apply those rules and the rules 
of Sec.  1.903-1(c)(2) and (d)(3), (4), and (8) through (11) to such 
taxable years.
* * * * *
0
Par 4. Section 1.903-1 is amended:
0
1. By revising paragraphs (c)(2) introductory text and (c)(2)(iii).
0
2. By adding paragraph (c)(2)(iv).
0
3. By revising paragraph (d)(3).
0
4. By removing and reserving paragraph (d)(4).
0
5. By adding paragraphs (d)(8) through (11).
0
6. By revising paragraph (e).
    The revisions and additions read as follows:


Sec.  1.903-1  Taxes in lieu of income taxes.

* * * * *
    (c) * * *
    (2) Covered withholding tax. A tested foreign tax is a covered 
withholding tax if, based on the foreign tax law (except as provided in 
paragraph (c)(2)(iii)(B) of this section), the requirements in 
paragraphs (c)(1)(i) and (c)(2)(i) through (iii) of this section are 
met with respect to the tested foreign tax. See also Sec.  1.901-
2(d)(1)(iii) for rules treating withholding taxes as separate levies 
with respect to each class of income subject to the tax, with respect 
to each subset of a class of income that is subject to different income 
attribution rules, or with respect to withholding tax that is imposed 
on a payment giving rise to gross royalty income of a nonresident that 
is made pursuant to a single-country license (as determined under 
paragraph (c)(2)(iv) of this section).
* * * * *
    (iii) Source-based attribution requirement. The income subject to 
the tested foreign tax satisfies the requirements in paragraph 
(c)(2)(iii)(A) or (B) of this section.
    (A) The income subject to the tested foreign tax satisfies the 
attribution requirement described in Sec.  1.901-2(b)(5)(i)(B).
    (B) The income subject to the tested foreign tax is characterized 
as royalty income and the payment giving rise to such income is made 
pursuant to a single-country license as determined under paragraph 
(c)(2)(iv) of this section. For purposes of this paragraph 
(c)(2)(iii)(B) and paragraph (c)(2)(iv) of this section, whether the 
income is characterized as royalty income is determined under the 
foreign tax law, except that income from the sale of a copyrighted 
article (as determined under rules similar to Sec.  1.861-18) is not 
characterized as royalty income regardless of the characterization of 
the income under the foreign tax law.
    (iv) Single-country license--(A) In general. Except as otherwise 
provided in this paragraph (c)(2)(iv), for purposes of paragraph 
(c)(2)(iii)(B) of this section, a payment is made pursuant to a single-
country license if the terms of the license agreement pursuant to which 
the payment is made characterize the payment as a royalty and limit the 
territory of the license to the foreign country imposing the tested 
foreign tax.
    (B) Separately stated portions. If a written agreement that is not 
described in paragraph (c)(2)(iv)(A) of this section separately states 
a portion (whether as a specified amount or as a formula) of the 
payment subject to the tested foreign tax and such portion is both 
characterized as a royalty under the terms of the agreement and is 
attributable to the part of the territory of the license that is solely 
within the foreign country imposing the tested foreign tax, then that 
portion of the payment is treated as made pursuant to a single-country 
license.
    (C) Validity of agreement. A payment is considered not made 
pursuant to a single-country license if the taxpayer knows, or has 
reason to know, that the terms of the agreement pursuant to which the 
payment is made misstate the territory in which the relevant intangible 
property is used or overstate the amount of the royalty with respect to 
the part of the territory of the license that is solely within the 
foreign country imposing the tested foreign tax. A taxpayer is 
considered to have reason to know if its knowledge of relevant of facts 
or circumstances is such that a reasonably prudent person in the 
position of the taxpayer would question whether the terms of the 
agreement misstate the territory in which the relevant intangible 
property is used or overstate the amount of a royalty. For purposes of 
this section, the principles of sections 482 and 861 apply to determine 
whether the terms of the agreement misstate the territory in which the 
relevant intangible property is used or overstate the amount of a 
royalty. See paragraph (d)(11) of this section (Example 11).
    (D) Documentation. A taxpayer must provide the agreement described 
in paragraph (c)(2)(iv)(A) or (B) of this section, as applicable (the 
``required agreement''), within 30 days of a request by the 
Commissioner or another period as agreed between the Commissioner and 
the taxpayer. Except as provided in the next sentence, the required 
agreement pursuant to which the royalty is paid must be executed no 
later than the date of payment that gives rise to the gross royalty 
income that is subject to the tested foreign tax. In the case of a 
royalty that is paid before the date on which the required agreement is 
executed, in order to meet the requirement of this paragraph 
(c)(2)(iv)(D), the required agreement must be executed no later than 
May 17, 2023, and the agreement must state that royalties paid on or 
before the date of execution of the agreement are, for purposes of this 
paragraph (c)(2)(iv), considered paid pursuant to the terms of the 
agreement.
    (d) * * *


[[Page 71284]]


    (3) Example 3: Withholding tax on royalties; attribution 
requirement--(i) Facts. YCo, a resident of Country Y, is a 
controlled foreign corporation wholly owned by USP, a domestic 
corporation. In Year 1, YCo enters into a written license agreement 
(the ``Agreement'') with XCo, a resident of Country X unrelated to 
YCo or USP, for the right to use YCo's intangible property (``IP'') 
in a territory defined by the Agreement as the entire world, 
including Country X, in exchange for payments that the terms of the 
Agreement characterize as royalties. The payments made by XCo to YCo 
under the Agreement are also characterized as royalties under the 
laws of Country X. Under Country X's tax law, all gross royalty 
payments made by a Country X resident to a nonresident are treated 
as giving rise to Country X source income and are subject to a 20 
percent withholding tax, regardless of whether the nonresident payee 
has a taxable presence in Country X. Country X has a generally-
imposed net income tax within the meaning of paragraph (c)(1)(i) of 
this section, and nonresidents subject to the withholding tax on 
royalties are not also subject to a Country X net income tax on 
their royalty income. In Year 1, XCo withholds 20u (units of Country 
X currency) of tax on a 100u royalty paid to YCo under the 
Agreement.
    (ii) Analysis--(A) Separate levy. Under Sec.  1.901-
2(d)(1)(iii)(B)(1), Country X's withholding tax imposed on gross 
royalty income of nonresidents is treated as a separate levy. Under 
Sec.  1.901-2(d)(1)(iii)(B)(3), the 20u of Country X withholding tax 
imposed on the 100u of royalties paid by XCo to YCo is treated as a 
separate levy from the Country X withholding tax on royalties if the 
Agreement pursuant to which the royalties are paid is a single-
country license under paragraph (c)(2)(iv) of this section. The 
Agreement does not meet the requirements of paragraph (c)(2)(iv) of 
this section because it neither limits the territory of the license 
to Country X nor separately states the portion of the payment that 
is with respect to the part of the territory of the license that is 
solely within Country X. Thus, the 20u of Country X withholding tax 
paid by YCo is not treated as a separate levy under Sec.  1.901-
2(d)(1)(iii)(B)(3).
    (B) Covered withholding tax. Under paragraph (c)(2) of this 
section, a tested foreign tax is a covered withholding tax if 
paragraphs (c)(1)(i) and (c)(2)(i) through (iii) of this section are 
met. Country X's withholding tax on royalties meets the requirements 
of paragraphs (c)(1)(i) and (c)(2)(i) and (ii) of this section 
because Country X has a generally-imposed net income tax, Country 
X's withholding tax on the royalties paid pursuant to the Agreement 
is imposed on the gross royalty income of persons who are 
nonresidents of Country X, and nonresidents subject to the 
withholding tax on royalties are not also subject to the Country X 
generally-imposed net income tax on their royalty income. However, 
the Country X withholding tax on royalties paid pursuant to the 
Agreement does not meet the requirements of Sec.  1.901-
2(b)(5)(i)(B) and paragraph (c)(2)(iii)(A) of this section because 
Country X's sourcing rule for royalties (based on residence of the 
payor) is not based on the place of use of, or the right to use, the 
intangible property. Additionally, the payment that is subject to 
Country X's withholding tax is not made pursuant to a single-country 
license under paragraph (c)(2)(iv) of this section for the reasons 
described in paragraph (d)(3)(ii)(A) of this section (the separate 
levy analysis of this paragraph (d)(3) (Example 3)). Therefore, the 
requirement in paragraph (c)(2)(iii)(B) of this section is not met. 
Accordingly, the Country X withholding tax paid by YCo is not a 
covered withholding tax, and none of the 20u Country X withholding 
tax paid by YCo with respect to the 100u royalty payment made to XCo 
is a foreign income tax.
* * * * *
    (8) Example 8: Withholding tax on royalties; single-country 
license--(i) Facts. The facts are the same as in paragraph (d)(3)(i) 
of this section (the facts of Example 3) except that in Year 1, YCo 
enters into a written license agreement (the ``Agreement'') with XCo 
for the right to use YCo's IP in a territory defined by the 
Agreement as Country X, in exchange for payments that the terms of 
the Agreement characterize as royalties, and XCo in fact only uses 
the IP in Country X. In Year 1, XCo withholds 20u of tax from 100u 
of royalties paid to YCo under the Agreement.
    (ii) Analysis--(A) Separate levy. Under Sec.  1.901-
2(d)(1)(iii)(B)(1), Country X's withholding tax imposed on gross 
royalty income of nonresidents is treated as a separate levy. Under 
Sec.  1.901-2(d)(1)(iii)(B)(3), the 20u of Country X withholding tax 
imposed on the 100u of royalties paid by XCo to YCo is treated as a 
separate levy from the Country X withholding tax on royalties if the 
Agreement pursuant to which the royalties are paid is a single-
country license under paragraph (c)(2)(iv) of this section. The 
Agreement meets the requirements of paragraph (c)(2)(iv)(A) of this 
section because it is a written license agreement that characterizes 
the payment as a royalty and limits the territory of the license to 
Country X. Thus, the 20u Country X withholding tax paid by YCo is 
treated as a separate levy under Sec.  1.901-2(d)(1)(iii)(B)(3).
    (B) Covered withholding tax. Under paragraph (c)(2) of this 
section, a tested foreign tax is a covered withholding tax if 
paragraphs (c)(1)(i) and (c)(2)(i) through (iii) of this section are 
met. Country X has a generally-imposed net income tax, Country X's 
withholding tax on the royalties paid pursuant to the Agreement is a 
withholding tax that is imposed on the gross income of persons who 
are nonresidents of Country X, and nonresidents subject to the 
withholding tax on royalties paid pursuant to the Agreement are not 
also subject to a net income tax on their royalty income. Thus, the 
requirements of paragraphs (c)(1)(i) and (c)(2)(i) and (ii) of this 
section are met. The withholding tax paid by YCo does not meet the 
requirements of Sec.  1.901-2(b)(5)(i)(B) and paragraph 
(c)(2)(iii)(A) of this section because Country X's source rule for 
royalties (based on residence of the payor) is not based on the 
place of use of, or the right to use, the intangible property. 
However, the payment that is subject to Country X's withholding tax 
is made pursuant to a single-country license under paragraph 
(c)(2)(iv) of this section for the reasons described in paragraph 
(d)(8)(ii)(A) of this section (the separate levy analysis of this 
Example 8). Therefore, the requirement in paragraph (c)(2)(iii)(B) 
of this section is met. Accordingly, the Country X withholding tax 
on the payment made by XCo to YCo pursuant to the Agreement is a 
covered withholding tax and all of the 20u of Country X withholding 
tax paid by YCo with respect to the 100u of royalties under the 
Agreement is a foreign income tax.
    (9) Example 9: Withholding tax on royalties; separately stated 
portion--(i) Facts. The facts are the same as in paragraph (d)(3)(i) 
of this section (the facts of Example 3) except that in Year 1, YCo 
enters into a written agreement (the ``Agreement'') with XCo for the 
right to use YCo's IP in a territory defined by the Agreement as the 
entire world, as well as for YCo to provide certain services to XCo 
in Country Y, in exchange for a payment equal to 10 percent of XCo's 
annual revenue. The Agreement provides a formula for determining the 
amount of the payment that is characterized as a royalty and that is 
with respect to the part of the territory that is within Country X 
(the ``separately stated formula''). The separately stated formula 
provides that the first 30u of the payment represents payment for 
services provided by YCo, and that 40 percent of the remainder of 
the payment represents payment of a royalty with respect to the part 
of the territory of the license that is solely within Country X. The 
portion of the payment by XCo to YCo that is characterized as 
services income under the Agreement is also characterized as 
services income under the laws of Country X. Additionally, all 
payments by a resident of Country X for services provided by a 
nonresident are treated as giving rise to Country X source income, 
regardless of where the services are performed, and gross income 
from services is subject to the same 20 percent withholding tax as 
gross royalty income. In Year 1, XCo earns gross income of 1,800u 
and pays YCo 180u under the Agreement. XCo withholds 12u of tax from 
the 60u of royalties attributable to the part of the territory of 
the license that is solely within Country X that are paid to YCo 
under the separately stated formula in the Agreement. The portion of 
the payment by XCo to YCo that is characterized as a royalty with 
respect to the part of the territory of the license that is solely 
within Country X under the separately stated formula in the 
Agreement is also characterized as a royalty under the laws of 
Country X. XCo withholds 24u of tax from the remaining 120u payment 
paid to YCo under the Agreement, consisting of 6u of tax on the 30u 
payment for services and 18u of tax on 90u of royalties. YCo does 
not know, or have reason to know, that the terms of the Agreement 
misstate the territory in which YCo's IP is used or overstate the 
amount of the royalty with respect to the part of the territory of 
the license that is solely within Country X.
    (ii) Analysis--(A) Separately stated portion. The analysis is 
the same as in paragraph (d)(8)(ii) of this section (the

[[Page 71285]]

analysis of Example 8), except that the portion of the payment that 
is a royalty with respect to the part of the territory of the 
license that is solely within Country X under the separately stated 
formula in the Agreement is treated as made pursuant to a single-
country license under paragraph (c)(2)(iv) of this section because 
the Agreement is a written agreement that separately states the 
portion of the payment that is characterized as a royalty and that 
is with respect to the part of the territory of the license that is 
solely within Country X. Thus, the Country X withholding tax on the 
portion of the payment from XCo to YCo that is a payment of a 
royalty with respect to the part of the territory of the license 
that is solely within Country X under the separately stated formula 
under the Agreement is a separate levy and a covered withholding 
tax. Accordingly, the 12u Country X withholding tax paid by YCo from 
the 60u of royalties with respect to the part of the territory of 
the license that is solely within Country X is a foreign income tax.
    (B) Remaining portion of royalties. The analysis is the same as 
paragraph (d)(3)(ii) of this section (the analysis of Example 3). 
Specifically, the 18u Country X withholding tax on the 90u royalty 
payment that is not with respect to the part of the territory that 
is within Country X is neither a separate levy nor a covered 
withholding tax. Accordingly, none of the 18u Country X withholding 
tax paid by YCo with respect to the remaining 90u royalty payment 
under the Agreement is a payment of foreign income tax.
    (C) Services portion. Under Sec.  1.901-2(d)(1)(iii)(B)(1), 
Country X's withholding tax imposed on gross services income of 
nonresidents is a separate levy. The Country X withholding tax of 6u 
on the 30u payment for services made by XCo to YCo under the 
Agreement is not a covered withholding tax. The withholding tax paid 
by YCo does not meet the requirements of Sec.  1.901-2(b)(5)(i)(B) 
and paragraph (c)(2)(iii)(A) of this section because Country X's 
sourcing rule for services (based on residence of the payor) is not 
reasonably similar to the sourcing rule that applies under the 
Internal Revenue Code (based on where the services are performed). 
The special separate levy and covered withholding tax rules for 
single-country licenses under Sec.  1.901-2(d)(1)(iii)(B)(3) and 
paragraph (c)(2)(iii)(B) of this section do not apply to withholding 
taxes on payments for services. Accordingly, none of the 6u of 
Country X withholding tax paid by YCo with respect to the 30u 
payment for services under the Agreement is a payment of foreign 
income tax.
    (10) Example 10: Characterization of payment--(i) Facts. The 
facts are the same as in paragraph (d)(3)(i) of this section (the 
facts of Example 3), except that in Year 1, YCo enters into a 
written license agreement (the ``Agreement'') with XCo for the right 
to use YCo's IP in a territory defined by the Agreement as Country 
X, in exchange for a payment that the terms of the Agreement 
characterize as a royalty, but that is characterized as a payment 
for services under the laws of Country X, and all payments of 
services paid by a resident of Country X to a nonresident are 
treated as giving rise to Country X source income, regardless of 
where the services are performed, and are subject to a 20 percent 
withholding tax.
    (ii) Analysis. Under Sec.  1.901-2(d)(1)(iii)(B)(1), Country X's 
withholding tax imposed on gross services income of nonresidents is 
a separate levy. The Country X withholding tax of 20u on the 100u 
payment for services made by XCo to YCo under the Agreement is not a 
covered withholding tax. The withholding tax paid by YCo does not 
meet the requirements of Sec.  1.901-2(b)(5)(i)(B) and paragraph 
(c)(2)(iii)(A) of this section because Country X's sourcing rule for 
services (based on residence of the payor) is not reasonably similar 
to the sourcing rule that applies under the Internal Revenue Code 
(based on where the services are performed). The special separate 
levy and covered withholding tax rules for single-country licenses 
under Sec.  1.901-2(d)(1)(iii)(B)(3) and paragraph (c)(2)(iii)(B) of 
this section do not apply to withholding taxes on income that is not 
characterized as royalty income under the foreign tax law. 
Accordingly, none of the 20u Country X withholding tax paid by YCo 
with respect to the 100u paid under the Agreement is a payment of 
foreign income tax.
    (11) Example 11: Withholding tax on royalties, validity of 
agreement--(i) Facts. The facts are the same as in paragraph 
(d)(3)(i) of this section (the facts of Example 3), except that XCo 
is a controlled foreign corporation wholly owned by USP. 
Additionally, in Year 2, XCo and YCo cancel the written license 
agreement entered into in Year 1 and YCo enters into two new written 
license agreements with XCo, one agreement which grants XCo the 
right to use certain YCo IP in a territory defined as Country X (the 
``Country X Agreement''), and one of which grants XCo the right to 
use the same YCo IP in a territory defined as the entire world 
except for Country X (the ``Rest of World Agreement''). Both 
agreements characterize the payments under the agreements as 
royalties, and the payments are also characterized as royalties 
under the laws of Country X. In Year 2, XCo withholds a total of 20u 
of tax from a total of 100u of royalties paid to YCo under the 
Country X Agreement and the Rest of World Agreement. Based on the 
terms of each agreement, 18u of tax was withheld from 90u of 
royalties paid to YCo under the Country X Agreement, and 2u of tax 
from 10u of royalties paid to YCo under the Rest of World Agreement. 
YCo knew or had reason to know that under the principles of sections 
482 and 861, with respect to the 100u of royalties paid by XCo to 
YCo, 40u is attributable to XCo's use of YCo IP in Country X and 60u 
is attributable to use of YCo IP outside Country X.
    (ii) Analysis--(A) Rest of World Agreement. The analysis is the 
same as paragraph (d)(3)(ii) of this section (the analysis of 
Example 3). Specifically, the 2u Country X withholding tax on the 
10u royalty payment under the Rest of World Agreement is neither a 
separate levy nor a covered withholding tax. Accordingly, none of 
the 2u Country X withholding tax paid by YCo with respect to the 10u 
royalty payment under the Rest of World Agreement is a payment of 
foreign income tax.
    (B) Country X Agreement. The analysis is the same as paragraph 
(d)(3)(ii) of this section (the analysis of Example 3), except that 
the reason that the Country X Agreement does not meet the 
requirements of paragraph (c)(2)(iv) of this section is that YCo 
knew or had reason to know that the terms of the Country X Agreement 
overstate the amount of the royalty with respect to Country X. Thus, 
the 18u Country X withholding tax on the 90u royalty payment under 
the Country X Agreement is neither a separate levy nor a covered 
withholding tax. Accordingly, none of the 18u Country X withholding 
tax paid by YCo with respect to the 90u royalty payment under the 
Country X Agreement is a payment of foreign income tax.

    (e) Applicability dates--(1) In general. Except as provided in 
paragraphs (e)(2) and (3) of this section, this section applies to 
foreign taxes paid (within the meaning of Sec.  1.901-2(g)) in taxable 
years beginning on or after December 28, 2021. For foreign taxes that 
relate to (and if creditable are considered to accrue in) taxable years 
beginning before December 28, 2021, and that are remitted in taxable 
years beginning on or after December 28, 2021, by a taxpayer that 
accounts for foreign income taxes on the accrual basis, see Sec.  
1.903-1 as contained in 26 CFR part 1 revised as of April 1, 2021.
    (2) Certain foreign taxes paid to Puerto Rico. For foreign taxes 
paid to Puerto Rico under section 3070.01 of the Puerto Rico Internal 
Revenue Code of 2011, as amended (13 L.P.R.A. 31771) (imposing an 
excise tax on a controlled group member's acquisition from another 
group member of certain personal property manufactured or produced in 
Puerto Rico and certain services performed in Puerto Rico), this 
section applies to foreign taxes paid (within the meaning of Sec.  
1.901-2(g)) in taxable years beginning on or after January 1, 2023. For 
foreign taxes described in the preceding sentence that are paid in 
taxable years beginning before January 1, 2023, see Sec.  1.903-1 as 
contained in 26 CFR part 1 revised as of April 1, 2021.
    (3) Modifications to the covered withholding tax rules. Paragraphs 
(c)(2) and (d)(3), (4), and (8) through (11) of this section apply to 
foreign taxes paid (within the meaning of Sec.  1.901-2(g)) in taxable 
years ending on or after November 18, 2022. For foreign taxes that are 
paid in taxable years ending before November 18, 2022, see Sec.  1.903-
1(c)(2) and (d)(3) and (4) as contained in 26 CFR part 1 revised as of 
July 27, 2022. Taxpayers may choose to apply the rules in paragraphs 
(c)(2) and (d)(3), (4), and (8) through (11) of this section to foreign 
taxes paid in taxable years beginning on or after December 28, 2021, 
and ending before November 18,

[[Page 71286]]

2022, provided that they consistently apply those rules and the rules 
of Sec.  1.901-2(b)(5)(i)(B)(2) and (d)(1)(iii) to such taxable years.

Melanie R. Krause,
Acting Deputy Commissioner for Services and Enforcement.
[FR Doc. 2022-25337 Filed 11-18-22; 11:15 am]
BILLING CODE 4830-01-P