Tax Tech Group Criticizes Proposed Foreign Tax Credit Regs

February 9, 2021

CC:PA:LPD:PR (REG–101657-20)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Guidance Related to the Foreign Tax Credit; REG-101657-20

Dear Sirs/Madams:

The Silicon Valley Tax Directors Group (“SVTDG”)¹ is pleased to submit our comments in response to the Notice of Proposed Rulemaking relating to certain aspects of the foreign tax credit.

We look forward to an opportunity to discuss our comments with you at your convenience.

Sincerely,

Robert F. Johnson
Co-Chair, Silicon Valley Tax Directors Group

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Written Submission in Response to Notice of Proposed Rulemaking Relating to the Foreign Tax Credit (REG-101657-20)

Silicon Valley Tax Directors Group

February 9, 2021

Introduction

The SVTDG commends Treasury and the Internal Revenue Service (“IRS”) for their work to provide clarity to taxpayers on the operation of the foreign tax credit and related rules.

The policy purpose of sections 901 and 903 is to relieve double taxation for resident taxpayers, not to be a policy tool to influence international norms or change behavior of foreign governments. As such, sections 901 and 903 should be flexible and operate neutrally to relieve double taxation, even as international standards may be evolving to more source-based taxation. As applied, these sections should not impose the burden of unrelieved double taxation on certain taxpayers in order to advance other policy interests of Treasury.

The jurisdictional nexus standard in the proposed regulations will create unrelieved double taxation for U.S. taxpayers subject to certain foreign taxes which have been in place for many years, and which clearly are creditable under the current regulations. The current regulations have been in place since 1983. Absent a statutory change reflecting new congressional intent, the proposed jurisdictional nexus standard would result in a complete reversal of result for certain withholding taxes on cross-border payments for goods and services, even though they clearly are creditable under existing law. We describe in this letter certain export transactions which are common among SVTDG members that will suffer unrelieved double taxation under the proposed regulations.

The proposed regulations as drafted will have a very broad effect on the creditability of many foreign taxes imposed on common cross-border transactions that have been creditable for decades. The proposed rule that foreign tax law on source and nexus must be reasonably similar to the Code for a foreign tax to be creditable is not consistent with the purpose of the statute to achieve effective double tax relief. That premise also conflicts with the fact that in many cases, particularly in the case of source rules for services and for sales of inventory property, U.S. tax law includes elements which are atypical compared to prevailing international norms. The proposed regulations would also appear to target the Amount A reallocation and nexus rules as proposed in the Pillar 1 Blueprint of the OECD Inclusive Framework.

Absent a change in the statute, we question whether Treasury has authority to change its position in regulations to require the diametrically opposite result from that which has been expressly incorporated in regulations for decades. Unless modified to remove the assumption that only U.S. law can be a point of reference for “accepted international standards,” these regulations will create unrelieved double taxation for many U.S. taxpayers subject to these long-standing and internationally accepted taxes without creating a significant deterrent effect on foreign governments relating to the novel unilateral measures.

We commend Treasury for its continued opposition to digital service taxes (DSTs) and other unilateral measures enacted or proposed by certain foreign governments intended to target U.S. companies. A DST was first proposed by the European Commission to be part of an EU Directive on the taxation of digital services. While that proposal was not adopted by the EU Member States, several individual countries thereafter enacted a national DST or equivalent. As of now, there are 11 countries which have enacted a DST or are in an advanced legislative stage of considering a DST.²

The United States Trade Representative conducted investigations of several national versions of DSTs.³ The U.S. Trade Representative (“USTR”) has concluded with respect to Austria, France, India, Italy, Spain, Turkey, and the United Kingdom that these taxes are discriminatory against U.S. companies, burden U.S. commerce, and do not conform to international tax principles. ⁴ Other investigations remain open with respect to Brazil, the Czech Republic, the European Union, and Indonesia. ⁵

We agree wholeheartedly that these taxes reflect poor tax policy choices by foreign governments, and that they will have a disproportionate effect on U.S. taxpayers. We also believe that Treasury's principal focus should be on taking those actions through international bodies and direct bilateral discussions that offer the only realistic path to remove or mitigate these taxes.

Our comments respond principally to the proposed rules regarding “covered withholding taxes” imposed on nonresidents, as defined in in Prop. Treas. Reg. § 1.903-1(c)(2), including the incorporation of the “jurisdictional nexus” rule based on source of income in Prop. Treas. Reg. § 1.901-2(c)(1)(ii). In particular, our comments respond to the request stated in the preamble for comments “on the extent to which the new jurisdictional nexus requirement may impact the treatment of other types of foreign taxes, and on alternative approaches the Treasury Department and the IRS may consider to modify the rules to achieve the policy objectives described” in the preamble.⁶

Discussion

1. Double Taxation Consequences of Proposed Regulations

The proposed jurisdictional nexus standard will create unrelieved double taxation for U.S. taxpayers subject to certain foreign taxes which have been in place for many years, and which clearly are creditable under the current regulations. The current regulations have been in place since 1983. Absent a statutory change reflecting new congressional intent, the proposed jurisdictional nexus standard would result in a complete reversal of result for certain withholding taxes on cross-border payments for goods and services, even though they clearly are creditable under existing law. We describe in this letter certain export transactions which are common among SVTDG members that will suffer unrelieved double taxation under the proposed regulations.

A. Withholding taxes on cross-border payments for services

Most countries, including the U.S., impose taxes on the provision of services which are deemed to have a local source. In many countries, nexus to tax a nonresident on the supply of services is based not on the location of performance of the service, but rather on whether the payment is made by a resident taxpayer, or a nonresident with a PE in the country. In our experience, this latter rule is by far the most common rule globally.

While U.S. treaty policy is to discourage gross-based taxes on all categories of business payments, the U.S. has entered into many treaties where the foreign government is allowed to exercise its domestic taxing authority over services.⁷ The UN Model today preserves the right of payor states to impose withholding tax on a variety of cross-border service payments.⁸

Withholding taxes are justified as a tax policy matter on various grounds, including addressing base erosion resulting from the payment of fees which extract profits from the market jurisdiction tax base, administrative efficiency in tax collection, tax allocation equity for developing countries, and other reasons. In U.S. law, the tax policy of the Base Erosion and Anti-Abuse Tax (“BEAT”) also is to address base erosion via deductible payments of service fees by resident taxpayers. In that respect, foreign source-based taxes on services have a clear analogue in U.S. law.

The current section 903 regulations recognize that these taxes are a normal part of the international tax system, and expressly allow a credit for such taxes. In particular, the regulations under section 903 include an example in which country X imposes a tax on realized net income that is generally imposed except that nonresidents are not subject to that tax. Nonresidents are subject to a gross income tax that is collected through withholding and that applies to payments for technical services performed outside country X. This example concludes that the item of income is eligible for a foreign tax credit even though the services are not performed in the payor country.⁹ The result in that example apparently will be reversed by the proposed regulations.

For SVTDG members, reversing the result in Example 3 creates the prospect of unrelieved double taxation on a wide variety of exported services. Trade in cross-border services is steadily increasing, and U.S. companies are at the forefront of developing and providing high-value services, in particular digital services. SVTDG members and other U.S. taxpayers operating in many sectors face withholding taxes in many countries on service payments, above and beyond liability for DSTs or the other recent unilateral measures.

SVTDG members are particularly concerned about the increasing incidence of foreign taxes on the export of cloud services. The proposed jurisdictional nexus rule apparently will create unrelieved double taxation in every case where foreign law imposes a withholding tax on the cross-border remittance of payments for cloud-based services. SVTDG members have complimented Treasury and the Service on the thoughtful classification rules in Prop. Treas. Reg. § 1.861-19 regarding cloud services, which confirm that essentially all cloud services as defined in those proposed regulations will be classified as a service for U.S. international tax purposes. As a consequence, however, in essentially every case where a withholding tax applies, a mismatch will occur between the U.S. and foreign source rules, causing unrelieved double taxation where those fees are subject to the normal foreign withholding tax.

B. Withholding taxes on cross-border payments for digital goods

SVTDG members also note that they are subject to withholding tax in various countries on payments for digital goods, most notably on software transactions which under Treas. Reg. § 1.861-18 are treated as sales of copyrighted articles. U.S. persons which purchase such copyrighted articles from foreign persons normally do not have a withholding tax obligation, as payments for inventory property generally are not FDAPI. Despite that classification, some foreign countries continue to regard some or all payments by their resident taxpayers for software copies as royalties, and accordingly impose a royalty withholding tax on payments to U.S. software providers, even in the case of sales of copyrighted articles. Even in cases where a foreign government may consider some cases of payments for software products to not be subject to royalty withholding tax, the foreign law still may tax other copyrighted article transactions as “royalties”, conflicting with the U.S. classification of the transaction.¹⁰

The proposed jurisdictional nexus standard may preclude a foreign tax credit in many cases of the export sale of software products or other digital goods, as under U.S. law the source of income for sales of many digital goods will be U.S. source. If the inventory property is produced in the U.S., Section 863(b), as amended by the Tax Cuts and Job Act, will cause all export sales of digital goods to be U.S. source income. Even if the digital good is not produced in the U.S., the relevant source rule of Treas. Reg. § 1.861-7(c) can cause the transaction to be U.S. source if the risk of loss to the digital good passes in the U.S. In these cases, a foreign withholding tax that is imposed on payments by a local resident would seem to fail the proposed transactional nexus rule.¹¹

We note that the jurisdictional nexus rule of Prop. Treas. Reg. § 1.901-2(c)(1)(ii) would not preclude the credit if the sourcing rules of the foreign tax law are “reasonably similar” to the U.S. source rules. Given that all exports of inventory property which are “produced” in the U.S. would be U.S. source income, we are concerned that a typical foreign rule that bases tax jurisdiction on the location of the payor could not be regarded as “reasonably similar” to the relevant U.S. source rule for the sale of digital goods.

Finally, the SVTDG notes that the proposed rule can create diametrically opposite foreign tax credit results for transactions that are economically similar. This is due to the fact that the source rule for foreign withholding taxes normally is the location of the payor, while U.S. source rules may or may not conform to that approach. One simple example is to compare the application of the jurisdictional nexus test to two different methods used to deliver software: (i) a SaaS provider which allows access to its software for a time-limited subscription period, compared to (ii) a software provider which makes its software available through downloads under a time-limited license. The SaaS payments are characterized as service fees, and thus have a source under U.S. law at the provider's location. The limited duration license payments are classified as rents, and thus have a source under U.S. law at the location where the user has installed the copy. Assuming a foreign withholding tax on both payments, the SaaS provider will suffer unrelieved double taxation, while the limited duration license provider will not. There is no good policy justification for the different treatment.

C. Migration towards a service economy

The global economy increasingly is becoming a service economy, with the increase in digital services being particularly notable. U.S. companies are leaders in development of the high-value service sector. At the same time, many countries around the world are imposing withholding taxes on payments to non-residents as part of their normal withholding tax regimes, separate and apart from DSTs or other unilateral measures. Denying credits for these long-standing withholding taxes will place U.S. taxpayers in systemic double taxation situations in markets where they should be expanding.

2. Statutory Purpose of Sections 901 and 903 and Relationship to Other Tax Systems

A. Relief from double taxation

The policy purpose of sections 901 and 903 is to relieve double taxation for resident taxpayers, not to be a policy tool to influence international norms or change behavior of foreign governments. As such, sections 901 and 903 should operate neutrally to relieve double taxation. As applied, these sections should not impose the burden of unrelieved double taxation on certain taxpayers in order to advance other policy interests of Treasury.

In general, tax systems around the world adopt either the exemption method or the credit method to relieve double taxation. Congress chose the credit method. Once Congress made that choice, Treasury should allow the system to work as expected to relieve double taxation for income taxes (and “in lieu of” taxes) for taxes that are typical in the international tax framework.

The proposed regulations apparently agree with the proposition that double tax should be relieved for all income taxes that are typical in the international tax framework. The Preamble sets out the basic policy foundation that for a credit to be allowed, the foreign tax “must conform with established international norms”.¹² The proposed regulations then implement that policy foundation by precluding credits unless the foreign tax system follows nexus rules reasonably similar to the U.S. concept of effectively connected income (“ECI”) of section 864(c), and source rules reasonably similar to the U.S. source rules in sections 861-865. By interpreting “established international norms” to mean only those systems which mirror the rules as “reflected in the Internal Revenue Code and related guidance”, the proposed regulations essentially say that only U.S. domestic law, with all of its nuances and special cases resulting from decades of amendments, defines “established international norms”.

B. U.S. domestic tax law does not uniquely define established international norms

The SVTDG believe that defining international norms by reference only to U.S. domestic law is not a reasonable interpretation of the concept of “established international norms”. The U.S. ECI and source rules have many peculiarities, as the discussion above regarding the source of income from the sale of digital goods demonstrates. Further, the most common source rule around the world for withholding tax is based on the location of the payor, so the U.S. rules which source income from sales of goods, services, and in some cases royalties, actually differ significantly from “established international norms”.

The source rule for services is the U.S. rule which differs most dramatically from international norms for assigning jurisdiction to tax nonresident service providers. Further, the source analysis for sales of digital goods described above involving the interaction of section 863(b) and the title passage rule has no reasonably similar analogue in any country of which we are aware. The fact that the most recent amendment to section 863(b) was enacted only a few years ago to cause many software payments to be U.S. source, suggests that the current U.S. source rules as applied to income from sales of software copies which are inventory property cannot be regarded as the paradigm of “established international norms”.

The U.S. source rule for royalties in sections 861 and 862 is another case where the U.S. rule may provide a diametrically different result than the typical foreign rule. Outside the U.S., the most common source rule is that the country of residence of the payor may impose tax on royalties. The U.S. source rule deems the source of income to be in a country if the payment is for the use of or for the privilege of using the intellectual property in that state. The country where IP is used as defined may or may not also be the country of the payor.

Rev. Rul. 72-232, 1972-1 C.B. 276, is a clear example of a case where the U.S. rule and the typical foreign rule would reach different results. In that ruling, a nonresident individual extended to a publisher located in the U.S. a license to print and distribute certain textbooks to be used exclusively in a foreign country. The U.S. publisher printed the textbooks in the U.S. and paid a royalty to the nonresident licensor. The ruling concluded that the royalty was entirely foreign source income, despite being paid by, and presumably deducted by, a U.S. taxpayer. In contrast to that result, the laws of most foreign countries would treat that payment as sourced at the location of the payor. In this case, the U.S. source rule for copyright royalties is the unusual one.

The SVTDG believes that a credit system should recognize that less developed or capital importing countries will likely have a different set of tax policy goals than the U.S. There is no reason to expect or require that all foreign taxes should be designed like the U.S. ECI and source rules. The foreign tax credit regulations should not have the effect of picking and choosing among taxpayers to bear double taxation to advance political goals. The ongoing OECD IF Pillar 1 negotiations confirm that the rest of the world, including developed countries, is moving in a different direction than the U.S., and U.S. businesses should not be denied a tax credit for foreign taxes paid in countries that have a different perspective than the U.S. It should be noted that even the U.S. considered a destination-based income tax when considering tax reform in 2017.

C. Attributes of taxes which do deviate from international norms

We want to emphasize that the SVTDG firmly supports Treasury's policy goal to oppose the introduction of DSTs and other unilateral measures. The proposed jurisdictional nexus rule mechanically describes many of the most egregious unilateral measures, but by its incorporation as a general rule that regulates the creditability of all foreign levies, it casts too wide a net.

If Treasury wishes to identify attributes of taxes which do not conform to international norms, Treasury might consider criteria drawn from those that have been used by the USTR to conclude that certain DSTs are discriminatory and burden U.S. commerce. Those criteria could include, for example:

DSTs or other taxes that exhibit these features resemble tariffs or excise taxes more than income taxes. While the stated purpose of DSTs is to cause the targeted digital service suppliers to pay more tax in the states in which users are resident, the design features which focus on a certain sector and impact disproportionately U.S. companies causes these taxes to bear a closer resemblance to a tariff focused on a policy to restrict trade in certain goods or services than to an income tax which is designed neutrally to raise revenue to fund general government services. These features indicate that DSTs do not conform with international norms of income and “in lieu of” taxation.

3. Preamble's Reliance on Regulatory History is Misplaced

The preamble to the proposed regulations portrays the introduction of the jurisdictional nexus requirement as a change that is consistent with a set of temporary and proposed regulations released under section 901 in 1980 but withdrawn and replaced in 1983.¹³ It is true that the prior temporary and proposed regulations included a jurisdictional nexus requirement in Temp. Treas. Reg. § 4.901-2(a)(1)(iii). However, the flush language in Temp. Treas. Reg. § 4.901-2(a)(1) states that a foreign tax may satisfy the definition of an income tax “even if the provisions of the law of the foreign country [. . .] imposing the charge differ substantially from the income tax provisions of the [Code]. ” This text differs dramatically from the proposed jurisdictional nexus rule, and thus cannot be seen as providing support for the proposed rule based on regulatory history.

Similarly, the regulations proposed under section 903 in 1980 and withdrawn in 1983 do not support Treasury's assertion that the jurisdictional nexus requirement in the 2020 proposed regulations is aligned with the jurisdictional limitation proposed in 1980. The 2020 proposed regulations cite Temp. Treas. Reg. § 4.903-1(a)(4) which “requir[es] that an in lieu of tax follow 'reasonable rules of taxing jurisdiction within the meaning of § 4.901-2(a)(1)(iii).'”¹⁴ As noted above, the cross-reference to Temp. Treas. Reg. 4.903-1(a)(4) and 4.901-2(a)(1)(iii) do not support the interpretation that the jurisdictional nexus requirement, as stated in the 1980 proposed regulations, requires that the foreign tax be reasonably similar to U.S. tax rules.

The final version of the section 901 regulations that were published in 1983 replaced the concept of a jurisdictional limitation with the provision that a foreign levy is an income tax if it is a tax and the “predominant character of that tax is that of an income tax in the U.S. sense. ”¹⁵ The final regulations under section 903 do not cross-reference the requirement that a tax must be predominantly an income tax in the U.S. sense as provided in Treas. Reg. § 1.901-2(a)(1)(ii). Instead, Treas. Reg. § 1.903-1(a) requires only that the tax be a tax within the meaning of Treas. Reg. § 1.901-2(a)(2) (i.e., the compulsory payment rule) and that the tax meet the substitution requirement in Treas. Reg. § 1.903-1(b). Neither of the sections cross-referenced in Treas. Reg. § 1.903-1(a) contain or refer to a jurisdictional limitation-type rule.

Moreover, the final section 903 regulations include Example 3, which, as described above, demonstrates that withholding taxes on payments for services have been a long-standing feature of international tax norms, and expressly made creditable by Treasury regulations since 1983. That Example 3 has been included in the section 903 regulations since 1983 clearly shows that creditable taxes include taxes based on source rules that are not consistent with U.S. rules. Accordingly, the jurisdictional nexus requirement included in the 2020 proposed regulations is expressly inconsistent with the 1980 and 1983 regulations. The SVTDG believes it is important for foreign tax credit regulations to maintain flexibility to accommodate continued evolution of the international tax policy consensus away from the U.S. view of traditional tax norms.

4. Statutory Authority and Change in Regulatory Interpretation

The jurisdictional nexus requirement also has no basis in the statutory text of sections 901 and 903 and would therefore be an invalid exercise of regulatory authority. Treasury cannot add a requirement to the statute that is not already there.¹⁶ Section 901(b) merely provides that, subject to the limitations of section 904, a credit “shall be allowed” for “the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country.” Similarly, section 903 provides that “the term 'income, war profits, and excess profits taxes' shall include a tax paid in lieu of a tax on income, war profits, or excess profits otherwise generally imposed by any foreign country. ” Except as noted immediately below, nowhere does the statute prescribe, or even imply, a jurisdictional nexus requirement for a foreign tax to be creditable.

Other provisions of section 901 evince Congress's awareness, and imposition of, a much more narrowly targeted jurisdictional nexus requirement, further supporting the position that Congress did not intend to generally impose such a requirement on all otherwise creditable foreign taxes. For example, section 901(f) provides that taxes imposed on the purchase and sale of oil and gas extracted from a foreign country are not considered to be a tax “if the taxpayer has no economic interest in the oil or gas to which section 611(a) [relating to depletion and depreciation allowance for oil and gas wells] applies. ” The “economic interest” requirement is akin to a jurisdictional nexus requirement. Sections 901 and 903 are otherwise entirely silent on any type of jurisdictional nexus requirement.

Moreover, Congress's addition — since the 1983 promulgation of the current regulations — of numerous other limitations on taxpayers' ability to claim foreign tax credits demonstrates that if Congress intended to impose a jurisdictional nexus requirement it could and would have done so.¹⁷ For example, Congress introduced the predecessor to section 904 precisely because of a concern about the U.S. Treasury not funding (or otherwise subsidizing) foreign governments, a concern that appears to underlie Treasury and the IRS's intent in proposing the jurisdictional nexus requirement. Congress was aware and approved of the 1983 regulations' standards for creditability of foreign taxes, yet chose not to impose a jurisdictional nexus requirement.

In a similar vein, the proposed jurisdictional nexus requirement would undermine Congress 's decision to have (subject to section 904) an overall, rather than a per-country, foreign tax credit limitation. In connection with the Tax Reform Act of 1986, Congress specifically considered whether to retain an overall limitation or to return to the prior law per-country limitation. While acknowledging the taxpayer benefits of cross-crediting, Congress retained the overall limitation but decided to limit cross-crediting through the adoption of other limitations to the foreign tax credit, such as the basket/separate limitations included in section 904. Congress has retained an overall limitation approach since 1976.¹⁸ Adopting a jurisdictional nexus requirement now would effectively deny a foreign tax credit for foreign taxes that purport to tax income arising (under U.S. source principles) outside a foreign country, in contravention of Congress's express policy decision to apply an overall limitation.

Treasury and the IRS should therefore leave it exclusively to the purview of Congress to decide whether to impose a jurisdictional nexus requirement.

We note that in many cases, foreign withholding taxes will be imposed on payments received by CFCs in U.S. groups. U.S. groups suffer a 20% foreign tax credit disallowance on foreign taxes paid by CFCs under section 960(d). Excess credits for taxes paid or accrued with respect to amounts includible in gross income under section 951A are not available for carryback or carryover pursuant to section 904(c). The existing rules therefore already create cases where U.S. taxpayers are not able to fully utilize all foreign income taxes paid as credits. The SVTDG suggests that the existing system has sufficient limitations and safeguards, so that this proposal to eliminate creditability for a subset of existing taxes is not necessary to preserve the integrity of the U.S. foreign tax credit system.

5. Recommendation: Pursue the Policy Goal of Opposing Unilateral Measures through Available International Tax Policy Channels Rather than Through these Regulations

The SVTDG believes that the proposed regulations relating to the jurisdictional nexus test should be withdrawn. We believe that imposing the proposed jurisdictional nexus standard to limit credits claimed by U.S. taxpayers is highly unlikely to affect any legislative decision by any other government, especially while the Inclusive Framework process is still playing out. Adopting the proposed jurisdictional nexus standard will cause U.S. taxpayers to suffer unrelieved double taxation with respect to a wide variety of taxes which have been in place for many years, on account of a policy dispute between the U.S. and certain other countries over a relatively narrow set of new unilateral measures. The proposed regulations would also appear to limit the creditability of foreign income taxes imposed on the Amount A reallocation to markets as proposed in the Pillar 1 Blueprint of the OECD Inclusive Framework.

The Pillar 1 Blueprint which states the current state of the work of the Inclusive Framework is clear that participating countries are expected to remove relevant unilateral measures once the IF consensus has been implemented.¹⁹ Similarly, foreign governments have confirmed that they intend to remove their DSTs once the IF consensus has been implemented.²⁰

SVTDG Members which are subject to DSTs note that in many cases, digital service suppliers are not able to pass the cost of the DST onto customers. In those cases, the DST becomes a cost of the business. As all DSTs are imposed on gross revenue, these taxes constitute a significant cost that is imposed uniquely on suppliers of specified digital services.²¹

Accordingly, the SVTDG strongly supports and encourages continued U.S. government action on several international tax policy fronts.

A. OECD/Inclusive Framework negotiations

The United States should continue to take a leading role in these negotiations to achieve a fair result for U.S. taxpayers and the U.S. Treasury. In particular, we support continuing the focus on ensuring that all participating countries will withdraw all relevant unilateral measures. Treasury should ensure that the obligation to remove “all relevant unilateral measures” applies broadly to include, among others, all DSTs, the Indian Equalisation Levy, the U.K. Diverted Profits Tax, the Australian Multinational Anti-Avoidance Law, the U.K. tax on Offshore Receipts in respect of Intangible Property, taxes based on a significant digital presence, and all similar measures. If a reallocation of income without physical presence in a market jurisdiction under Amount A is adopted, under the proposed regulations foreign taxes on the reallocation would not be creditable. As such, foreign tax credit rules need to retain flexibility to accommodate the evolving international tax system.

B. International tax policy bodies

The U.S. should actively participate in international forums (such as the UN Committee of Experts) to oppose introduction of taxes that disproportionately affect U.S. companies. We are disappointed that the U.S. does not have a seat in the current UN Committee of Experts, and the absence of contributions from the U.S. and similarly minded countries undoubtedly facilitated discussion of proposals such as the current proposal to add a new Article 12B to the UN Model Convention. That proposed Article would allow source-based taxation of all cross-border gross payments for the supply of digital services, taxes which would not be creditable under the proposed regulations. The proponents of these taxes are well aware that the principal taxpayers will be U.S. companies.

C. Tax treaty review

U.S. taxpayers appreciate Treasury's diligent review and updating of our tax treaties. For specific countries that have imposed unilateral measures, Treasury should accelerate the schedule for bilateral treaty review and negotiate to eliminate those unilateral measures.

D. Bilateral trade agreements

The U.S. government also as a priority should address these issues through trade negotiations. For example, we believe that withdrawal of the U.K. unilateral measures should be a key discussion point for post-Brexit trade negotiations with the U.K. The upcoming free trade agreement negotiations with Kenya also should include a discussion that Kenya withdraw its DST. ²²

E. Section 301 process

USTR should continue the section 301 process now underway. If other countries pursue similar measures, USTR should, in consultation with other departments of the U.S. government, consider how best to oppose the further introduction of unilateral measures and to secure the withdrawal of existing DSTs.

6. Alternative Approaches to Guidance

In support of U.S. policy initiatives to object to unilateral measures, but also to avoid the overbroad reach of the proposed regulations, we would like to suggest a few alternative approaches for U.S. domestic guidance under sections 901 and 903. Our principal recommendation remains to withdraw the proposed regulations and vigorously pursue the policy channels noted above, but if Treasury and the IRS decide to issue guidance, we suggest consideration of the following amendments to the regulations to acknowledge the long-standing international tax policies that countries have followed to impose withholding taxes on payments for services and digital goods.

A. Services

As noted above, many countries around the world include in their domestic law a withholding tax for some or all services when paid by a resident of that country. The proposed regulations could recognize that reality of the international framework by modifying the jurisdictional nexus rule to apply differently to different types of transactions. In the case of services where the source is determined by the location of the payor, the regulations should accept that a tax on services imposed by the source country is consistent with international norms, and allow a credit for such taxes, as long as they satisfy all other requirements of the regulations.

B. Digital goods

A special rule also would be required to apply to taxes imposed on payments for the purchase or license of digital content, as defined in the proposed expansion of Treas. Reg. § 1.861-18. It has been clear for decades that the tax laws of some countries do not include classification principles similar to Treas. Reg. §1.861-18. In those cases, the applicable law may impose withholding tax on cross-border payments for software or other digital content. As noted above, in many cases the current U.S. source rules will treat many of those payments as U.S. source. Accordingly, if the proposed regulations continue to include a test that is based on the foreign law having source rules that are “reasonably similar” to U.S. source rules, an exception should be made for sales and licenses of copyrighted content.

A straightforward approach for this issue would be to deem the source of income nexus test satisfied for transactions within the scope of Treas. Reg. § 1.861-18. The policy foundation for this conclusion would be that a source based tax on payments for transactions described in Treas. Reg. § 1.861-18 is sufficiently common around the world, and has been for decades, that such taxes would be considered consistent with established international norms.

7. OECD/IF Work

We make these suggestions in full support of Treasury's policy goal to oppose the further adoption of unilateral measures around the world, and to encourage countries that have already enacted such measures to withdraw them. Towards that goal, we encourage strong U.S. leadership in the upcoming discussions at the OECD / Inclusive Framework to achieve the stated goal of the removal of all relevant unilateral measures as part of the completion of that project.

We note Treasury's recognition that if the proposed regulations are issued in final form, the introduction of new taxing rights as part of the Pillar 1 and Pillar 2 project may require some further attention to the section 901 and 903 regulations. Whatever form that guidance may take, we believe that the regulations should remain flexible to accommodate the evolving changes that are likely to occur in various countries.

We also suggest that the U.S. should implement the obligation to provide domestic double tax relief for the foreign tax on amounts that may be allocated under Amount A through an income exclusion rather than through a foreign tax credit. The extraordinary complexity of the U.S. foreign tax credit regime means that taxpayers cannot rely on that regime to adequately provide double tax relief for a novel taxing right such as that which will be represented by Amount A. Providing an income exclusion will be the far simpler and more effective means of providing relief than allowing a credit would be.

8. Other Issues in Proposed Regulations Relating to the Foreign Tax Credit

A. “Net Gain” requirement

The proposed regulations would largely replace the flexibility in the current regulations regarding whether a foreign tax reaches net gain “in the normal circumstances in which it applies” by replacing the empirical analysis required under the current regulations with more inflexible rules. The proposed regulations would make corresponding changes to the realization, gross receipts, and cost recovery/net income components of the net gain requirement. For example, the proposed regulations would remove the non-confiscatory gross basis tax rule in Treas. Reg. § 1.901-2(b)(4) and prescribe certain “significant costs and expenses” (such as interest and R&E) for which the foreign tax law must allow recovery against gross receipts.

We recommend that the changes to the net gain requirement in the proposed regulations should be withdrawn and the flexibility of the current regulations should be maintained. Similar to the jurisdictional nexus requirement, the proposed changes to the net gain requirement attempt to more strictly impose U.S. standards regarding the definition of an income tax on foreign countries.

B. Noncompulsory payments

i. Loss-sharing arrangements

The SVTDG generally endorses adoption of the exemption for loss surrender under group relief or other loss-sharing regimes from the noncompulsory payment regulations, which otherwise generally apply on a taxpayer-by-taxpayer basis.

ii. “Clarification” regarding requirement to minimize foreign taxes

The proposed regulations purport to “clarify” that the requirement for a taxpayer to reduce, over time, its liability for “foreign tax” applies only to “foreign income tax.”²³ We recommend that Treasury and the IRS should not adopt the change proposed in Prop. Treas. Reg. § 1.901-2(e)(5)(i). The proposed rule would put U.S. taxpayers at a significant disadvantage, and make it much more difficult for taxpayers, with respect to the settlement of foreign tax disputes. For example, taxpayers would not be able to trade the settlement of an income tax issue for the foreign tax authority agreeing to settle on a non-income tax issue, which has been the common practice of taxpayers for many years. The treatment of the income tax in such a situation as non-compulsory would be exacerbated by the disqualification of a variety of taxes as income taxes under the proposed jurisdictional nexus requirement.

C. Modifications to “substitution” test

i. “But for” test

The proposed regulations would apply a “but for” test as one (of four) requirement for purposes of determining whether the substitution requirement is satisfied. ²⁴ The “but for” test is a highly prescriptive standard that is satisfied “only if the imposition of such tested foreign tax bears a close connection to the failure to impose the generally imposed net income tax on the excluded income, ” which in turn requires that the income covered by the tested tax be “expressly excluded” from the generally imposed income tax.²⁵ Alternatively, taxpayers would be required to establish that the imposition of the tested foreign tax bears a “close connection” to the failure to impose the generally-imposed net income tax on the excluded income through an analysis of the foreign law 's legislative history.²⁶

We recommend that the “but for” test in Prop. Treas. Reg. § 1.903-1(c)(1)(iii) should not be adopted. Requiring taxpayers to establish that foreign law expressly excludes the relevant category of income from the generally imposed income tax or to research foreign legislative history is overly burdensome and unnecessary. Instead, we believe the non-duplication requirement in Prop. Treas. Reg. § 1.903-1(c)(1)(ii) should be sufficient for these purposes.

ii. Jurisdictional nexus requirement

The proposed regulations would incorporate the requirements of the proposed jurisdictional nexus requirement for purposes of determining whether an in lieu of tax satisfies the substitution requirement, including for a covered withholding tax. For the same reasons discussed above with respect to the proposed section 901 regulations, Treasury and the IRS should not adopt a jurisdictional nexus requirement for purposes of section 903.

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Appendix 1

10x Genomics, Inc.
Accenture
Activision Blizzard, Inc
Adobe Inc.
Advanced Micro Device Inc.
Agilent Technologies, I Airbnb, Inc.
Align Technology, Inc.
Alphabet Inc.
Amazon, Inc.
Ancestry.com Apple Inc.
Applied  Materials
Aptiv, Plc.
Arista Networks Inc
Atlassian Auth0, Inc.
Autodesk
BMC Software, Inc.
Broadcom Inc.
Cadence Design System Inc. 
Chegg, Inc.
Cisco Systems, Inc.
Citrix
Confluent
CrowdStrike Holdings, Inc.
Cypress Semiconductor
Dell Technologies
Dolby Laboratories, Inc
DoorDash
Dropbox, Inc. 
eBay
Electronic Arts
Expedia Group, Inc.
Facebook, Inc.
FireEye, Inc.
Fitbit, Inc.
Flex
Fortinet
Genentech Inc.
Genesys
Getaround
Gigamon Inc.
Gilead Sciences, Inc.
GLOBALFOUNDRIES
GlobalLogic
GoPro, Inc.
Hewlett Packard Enterprise
HP, Inc.
Indeed
Informatica
Ingram Micro, Inc.
Intel Corporation
Intuit Inc.
Intuitive Surgical, Inc.
Jazz Pharmaceuticals
Keysight Technologies, Inc.
KLA Corporation
Kraken
Lam Research Corporation
LiveRamp, Inc.
Marvell Semiconductor, Inc.
Maxim Integrated
Mentor Graphics
Microsoft Corporation
Netflix, Inc.
NortonLifeLock, Inc.
Nutanix Inc.
NVIDIA Corporation
Oracle Corporation
Palo Alto Networks
PayPal Holdings Inc
Pure Storage, Inc.
Qualcomm, Inc.
RingCentral Ripple Labs, Inc.
Robinhood Rubrik Inc.
salesforce.com
Seagate Technology
ServiceNow
Snap Inc. Snowflake Inc.
Splunk, Inc.
Stripe, Inc.
SurveyMonkey Synopsys, Inc.
The Cooper Companies
The Walt Disney Company Twilio Inc.
Twitter, Inc.
Uber
Unity Technologies
Velodyne LiDAR, Inc
Verifone
Veritas Technologies
Visa Inc.
Western Digital Workday Inc
Xilinx, Inc.
Xperi Holding Corporation Yelp Inc.
Zillow Group
Zoom Video
Communications, Inc.