Tax Certainty and Foreign Tax Credit Uncertainty

Under the pillar 1 and pillar 2 proposals endorsed by the OECD’s inclusive framework on base erosion and profit shifting, jurisdictions would have new and expanded taxing rights.¹ The components of (and issues raised by) pillars 1 and 2 are complicated, and the proposals understandably recognize the need for dispute prevention and dispute resolution measures, which they term “tax certainty.”

I find “tax certainty” to be an awkward term. First, it alludes to Benjamin Franklin’s aphorism about the only two certainties in life, and I have a feeling that the term “death certainty” probably will never catch on. Second, it evokes the uneasy role certainty plays when it comes to taxation. There is a specific amount that a taxpayer owes — a “sum certain,” if you will — but how one arrives at that specific number is often disputed and based on varying levels of confidence in interpretation and application of the law. Whatever doubts are reflected in the calculations, we accept that there is a specific amount of tax that the taxpayer owes to the relevant tax agency, and if the taxpayer and tax authority cannot agree on that number, then a court or other neutral arbiter will tell them what it is. Whatever my misgivings about the staying power of the term “tax certainty” may be, it is used by the inclusive framework and is a lot shorter than substitutes like “an institutionalized set of dispute prevention and dispute resolution measures.” So this article also adopts the term.

While pillars 1 and 2 were being developed, the U.S. Treasury Department was revisiting the foreign tax credit regulations. Revisions to the FTC regulations released at the end of 2021² significantly changed the rules for determining whether a foreign levy is creditable. The new regulations have forced taxpayers and tax practitioners to review (or, in many cases, examine carefully for the first time) a variety of foreign taxes to ascertain whether, and to what extent, the foreign taxes are creditable under the new rules.

These inclusive framework and FTC regulatory developments are not unrelated: The digital services taxes and other creative exercises of taxing rights by various countries led both to pillar 1 and to some of the new rules in the FTC regulations. Still, pillars 1 and 2 make fairly fundamental changes to jurisdictions’ taxing rights, and the preamble to the proposed regulations³ on which the final regulations are based acknowledges that the U.S. regulatory rules may need to be revised in response to OECD/G-20 developments.⁴

U.S. FTC rules are often described as complicated or complex. Perhaps the best analogy to the FTC’s series of limitations and restrictions, though, is that of an obstacle course. Getting past one obstacle simply means that you are still in the race and have earned the right to take on the next obstacle. This article focuses on one particularly tricky obstacle, the noncompulsory payment rules of reg. section 1.901-2(e)(5), specifically the “exhaustion of remedies” requirement of reg. section 1.901-2(e)(5)(v), and how the proposed tax certainty measures affect those rules.

Creditability of the New Taxing Rights

Given that we have recently adopted final regulations that would deny an FTC for at least some of the types of taxes under consideration in the pillars 1 and 2 proposals, taxpayers rightly have questions about whether, and to what extent, these foreign taxes are creditable.

Most of the discussion on this subject has focused on the direct question of creditability: whether the new taxing rights, especially regarding the taxes under pillar 1, would cause a foreign tax (or a part of a foreign tax that is considered a separate levy) not to meet the definition of foreign income tax under reg. section 1.901-2(a). There is a variety of concerns, but, at the very least, the sourcing and nexus rules under pillar 1 for amount A are not consistent with the attribution rules of reg. section 1.901-2(b)(5). This has led to some head-scratching over why the United States would adopt final regulations that would deny an FTC for at least some of the types of taxes that it has endorsed in negotiations on pillars 1 and 2.

How to modify reg. section 1.901-2(b)(5) so that these nascent taxes are creditable is an important question, but its answer will have to wait until the pillar 1, and probably pillar 2, rules become more settled. Once the rules are clear, there can be a relatively straightforward debate over whether (or which) taxes should be creditable and the appropriate targeted changes made to reg. section 1.901-2(b)(5).

So that we can move further along the obstacle course, let’s make a couple of big assumptions: (1) that pillars 1 and 2 are adopted (ignoring, for the moment, by whom and in what form); and (2) the foreign tax at issue is considered a foreign income tax under the final FTC regulations.

Regarding the second assumption, I will note that the method through which the new taxing right is implemented affects the analysis. It matters whether the pillars 1 and 2 changes are implemented through a treaty to which the United States is a party. If the new taxing rights proposed by pillar 1 or pillar 2 are implemented through a tax treaty, then they would be creditable under reg. section 1.901-2(a)(iii) if the United States has an updated bilateral income tax treaty with the jurisdiction imposing the tax or if the United States were to ratify a multilateral treaty covering the tax at issue. This question is likely more relevant for pillar 1, given the expectation that a multilateral instrument will be needed to permit its implementation. For pillar 2, the extent to which the new taxing rights would be implemented through domestic law or an international agreement is not clear.

Taxpayers should not hold their breath waiting for a pillar 1-imposed tax to qualify as creditable under reg. section 1.901-2(a)(iii). Even if an MLI implementing pillar 1 is developed, it will not help U.S. taxpayers unless the United States signs and ratifies the MLI. Further, given the Senate’s lethargy in approving even bilateral tax treaties, it may be quite a while before U.S. taxpayers could take advantage of reg. section 1.901-2(a)(iii) to credit a tax imposed under pillar 1 taxing rights.

Whether there is a ratified treaty covering pillar 1 or pillar 2 taxing rights, taxpayers have a strong fairness argument that the FTC regulations should be revised to permit creditability of taxes on income to which the United States has agreed in principle. Of course, transposing high-level political agreement into specific statutory or regulatory language is no easy matter, as demonstrated by the twists and turns in development of the pillar 2 model rules and guidance on pillar 1. Implementation of pillars 1 and 2 (if and when it occurs) will likely be a messy and drawn-out affair, and there could be disagreements on whether a specific tax is indeed consistent with the proposal to which the United States agreed.

Noncompulsory Payment Rules

Concluding that a taxing right exercised under pillar 1 or 2 qualifies as a foreign income tax only begins the inquiry. In other words, determining that a particular foreign tax meets the definition of income tax (or “tax in lieu of an income tax”) is a necessary step, but only the first step, in determining creditability. The foreign tax at issue must run the gantlet of other FTC limitations and restrictions before showing up as a credit on the taxpayer’s Form 1116 or Form 1118. All these tests are important — after all, one need flunk only one to have the foreign tax denied or delayed as creditable.

But this article focuses on only one such limitation: the noncompulsory payment rules of reg. section 1.901-2(e)(5). A payment to a foreign government is not compulsory, and therefore not creditable, to the extent that it “exceeds the amount of liability for foreign income tax under the foreign tax law.”⁵ To be a compulsory payment, the taxpayer generally must determine its foreign tax liability:

in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign tax law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer’s reasonably expected liability under foreign tax law for foreign income tax, and if the taxpayer exhausts all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer’s liability for foreign income tax (including liability pursuant to a foreign tax audit adjustment).⁶

The noncompulsory payment rules were designed for the more mundane single-taxpayer-single-tax-authority situations rather than the multilateral confabulations of pillars 1 and 2. Of course, the effect of the noncompulsory payment rules on pillars 1 and 2 taxing rights is only hypothetical now: Their actual application will depend on the specific rules adopted in pillar 1, the method for implementing pillars 1 and 2 (particularly whether the changes are adopted through legislation or through a tax treaty), and the taxpayer’s specific facts. Accordingly, even though the analysis below follows the rules in the current regulations, the novelty of the new tax provisions, especially those in pillar 1, will encourage taxpayers, the IRS, or both to seek to revise reg. section 1.904-2 to reflect the new rules and paradigms.

I recognize that some of the discussion in this article may seem premature. After all, significant uncertainty exists about which jurisdictions will adopt pillars 1 and 2 and, for those jurisdictions that claim to adopt aspects of one or both pillars, how closely the tax rules will correspond to the model rules and agreements developed by the inclusive framework or OECD secretariat. Still, it is important to analyze the impact of the dispute prevention and resolution of pillars 1 and 2, even if one doubts that the model rules or agreements will be widely adopted. Whether that pessimism (or optimism, depending on one’s perspective) is true, the approaches set forth in the model rules, their commentary, and the preceding publications of the inclusive framework are effectively a pantry from which jurisdictions are likely to raid as they develop tax proposals in the future.

For the benefit of those who may be on, rather than at, the dinner table, the rest of this article discusses how the proposed tax certainty provisions interact with the noncompulsory payment rules, particularly the requirement that the taxpayer exhaust its remedies.

Elections or Choices Granted to a Taxpayer

The opportunity to elect or choose between alternative calculations of tax can create problems for taxpayers under the noncompulsory payment rules. Reg. section 1.901-2(e)(5)(iii)(A) states that if foreign tax law provides a taxpayer with options or elections in computing its liability for foreign income tax so that the taxpayer’s foreign income tax liability may be permanently decreased in the aggregate over time, the taxpayer’s failure to use these options or elections generally results in a higher foreign payment than the taxpayer’s liability for foreign income tax. The regulations draw a distinction, however, between elections and choices that shift liability from one year to another and those that increase or decrease tax liability permanently.⁷

Suppose that a jurisdiction gives a taxpayer a choice between paying a DST and paying tax computed under normal pillar 1 principles. If the income tax under pillar 1 principles is eligible for an FTC, then the taxpayer would prefer to pay it rather than the non-creditable DST. But if the taxpayer would have paid less tax under the DST rather than the pillar 1 tax, electing to pay the (higher) pillar 1 tax converts it into a noncompulsory tax⁸ (see reg. section 1.901-2(e)(5)). On the other hand, if the taxpayer has the choice between two different taxes, both of which are creditable, the taxpayer is permitted an FTC, but only for the tax that results in the lower tax liability, regardless of whether the taxpayer chose the tax with the higher or lower tax liability (see reg. section 1.901-2(e)(5)(iii)(C)).

At least in theory, if a jurisdiction gives a taxpayer a choice of compliance with a creditable pillar 1 tax or a non-creditable DST, the taxpayer could credit the pillar 1 tax only to the extent that it is less than the taxpayer would have owed under the DST (see reg. section 1.901-2(e)(5)(iii)(A)). Of course, how the taxpayer would know these alternative tax liabilities by the time its U.S. tax return is due is another matter.⁹

The noncompulsory payment rules of reg. section 1.901-2(e)(5) are premised on there being a single taxpayer and a single foreign tax authority. Applying these rules in the multiparty context of pillar 1 or 2 raises a host of practical questions. First, by imposing responsibility on the taxpayer for reducing foreign tax liability, the existing rules assume that the taxpayer controls the decisions about whether to make an election, how to interpret foreign law, which option to adopt, and so forth. In both pillars 1 and 2, tax liability decisions will often be made by one or more group entities other than the taxpayer.

So how should the noncompulsory payment rules work if the group member responsible for elections, options, and so forth chooses a path that results in less tax for Country A but more for Country B? Is the taxpayer in Country A subject to a loss of FTC under the noncompulsory payment rules? Does it matter whether the decision results in less overall combined tax liability of the group? Reg. section 1.901-2(e)(5)(iv), which permits one taxpayer to increase liability in one jurisdiction in exchange for a related party’s greater reduction in tax liability in a second jurisdiction, anticipates a situation like this. However, reg. section 1.901-2(e)(5)(iv) would have to be expanded to apply beyond the anti-hybrid rules to permit relief in this pillar 1 or 2 case.

Effect of Tax Certainty Provisions

Although elections and options in a multiparty context raise difficult issues about noncompulsory payment rules, I suspect that the regulation writers have enough creativity to revise the existing rules to address the increased possibilities. The general rule could remain untouched, with the addition of a targeted rule, like the exception for application of foreign anti-hybrid rules in reg. section 1.901-2(e)(5)(iv), to deal with the expected “lead taxpayer” scenarios in pillars 1 and 2. More difficult to address, however, is the exhaustion of remedies requirement of reg. section 1.901-2(e)(5)(v).

Some of the exhaustion of remedies questions are just knottier versions of the questions that arise in the noncompulsory payment rules more generally. As noted above, the group member making decisions that directly or indirectly affect a member’s tax liability in a particular jurisdiction may not be the taxpayer located in the jurisdiction imposing the tax. While this general problem can be addressed (at least conceptually) by looking at changes in group (rather than individual company) net tax liability in some cases, there remain the administrative and legal constraints on who can make decisions that bind the specific taxpayer and tax authority in question. Note that this “group” decision issue arises in the regulations in reg. section 1.901-2(e)(5)(iii)(B)(2), which addresses foreign consolidation, group relief, or other loss-sharing regimes.¹⁰ The conclusion reached by reg. section 1.901-2(e)(5)(iii)(B)(2) — that the taxpayer’s decision not to participate in a foreign consolidation, group relief, or other loss-sharing regime is not considered to convert the tax paid by the taxpayer into a noncompulsory payment — allows the regulation to skip over whether the “taxpayer” really controls this decision (as opposed to another group member). Thus, the question whether the noncompulsory payment rules can punish a taxpayer for a decision made by a related party is not squarely faced.

To simplify the analysis as much as possible, the remainder of this article assumes that the person responsible for tax in a particular jurisdiction is also the group member responsible for decisions regarding tax certainty. Granted, when it comes to tax certainty, we do not know what tax dispute prevention and resolution mechanisms jurisdictions will adopt. As of now, our only guides are the progress report on amount A of pillar 1¹¹ and the public consultation document on tax certainty in pillar 2.¹² It is unclear what provisions will be included in pillar 1 implementation guidance or what dispute resolution or prevention measures will be recommended as part of pillar 2. Still, we can use the approaches set forth in the progress report and the public consultation document to explore the issues that will arise under the exhaustion of remedies requirement.

Failure to Use Tax Certainty Provisions

Suppose a company believes that it is a member of an out-of-scope group, and its group does not take advantage of a scope certainty review.¹³ Now suppose a jurisdiction disagrees that the company is a member of an out-of-scope group and seeks to tax the company under amount A.

As an initial matter, whether the failure to take advantage of the scope certainty review should be taken into account in determining whether the company exhausted its remedies should depend on whether the jurisdiction at issue would have been bound by the scope certainty review. According to the progress report,¹⁴ “a Group would submit a request for a Scope Certainty Review to its Lead Tax Administration as soon as it has sufficient information to support its case.” Under this framework, a key question is whether the jurisdiction that is seeking to impose pillar 1 tax on the company would have been a listed party.

If so, the IRS could argue that by forgoing scope certainty review, the taxpayer failed to “exhaust all effective and practical remedies.” To rebut this charge, the taxpayer would have to argue that scope certainty review was not effective and practical in this case; that is, the cost of pursuing it was not reasonable considering the amount at issue and the likelihood of success.¹⁵ Granted, this is all hypothetical, but if the scope certainty review process works as intended, it will be hard for the taxpayer to take the position that the likelihood of success was low. For this argument to be available, the taxpayer must reasonably conclude that the costs of pursuing scope certainty review are not worth the potential reduction (if any) in foreign tax liability.

If the taxing jurisdiction would not have been one of the initial listed parties, then the taxpayer has a stronger case that its failure to pursue scope certainty review does not count against it in determining whether it exhausted its remedies. The taxpayer would have benefited from scope certainty review only if the jurisdiction imposing the tax was a listed party. For the foreign tax to be disallowed under reg. section 1.901-2(e)(5)(v) solely because the taxpayer failed to take advantage of scope certainty review, one would have to conclude that if the taxpayer pursued scope certainty review, the jurisdiction would have been added as a listed party. The possibility that the jurisdiction in question would have successfully petitioned to be included as a listed party seems too speculative to penalize the taxpayer. However, if the taxpayer never submits a request for scope certainty review to its lead tax administration, then it will be unclear who the initial listed parties would have been. So even this argument will never be completely safe for the taxpayer.

Let’s consider a second scenario. A company is a member of an in-scope group, and the group does not take advantage of advance certainty review.¹⁶ A jurisdiction’s tax authority seeks to impose tax on a group company challenging the group’s method of sourcing revenue or method for calculating excluded revenues. This situation lacks the distraction of whether the taxing jurisdiction would have been a listed party. Presumably, had the taxpayer participated, it would have received an answer regarding taxation, and one that other jurisdictions would have had to respect. Accordingly, to argue that the taxpayer exhausted its remedies, the taxpayer may have to demonstrate that it reasonably expected the costs of pursuing advance certainty review to outweigh the benefits.

Finally, let’s consider the consequences of not seeking comprehensive certainty review.¹⁷ Assume that the taxpayer is a member of an in-scope group, and the group does not take advantage of a comprehensive certainty review. Suppose a jurisdiction that is a party to the relevant convention challenges an aspect of the tax owed to that jurisdiction, and the jurisdiction asserts that, had the taxpayer sought comprehensive certainty review, the jurisdiction would have challenged the taxpayer’s calculation of tax owed to that jurisdiction.

As in the discussion above regarding scope certainty review, the first question is whether the jurisdiction is a party to the agreement providing for comprehensive certainty review. If not, then the taxpayer’s failure to seek comprehensive certainty review should not matter; rather, the question of exhaustion of remedies would be the regular single-taxpayer-single-tax-authority analysis set forth in the FTC regulations.

If the jurisdiction is a party to an agreement providing for comprehensive certainty review, then we find ourselves in an environment in which the familiar and unfamiliar are mixed in perplexing ways, kind of like in a Hieronymus Bosch triptych. One could reasonably conclude, as a policy matter, that this aspect of the tax certainty process is simply too interactive among members of the group to be evaluated. In that case, the decision to seek (or not to seek) comprehensive certainty review would be analogous to a taxpayer’s decision not to participate in a foreign consolidation, group relief, or other loss-sharing regime and would not affect whether a specific taxpayer exhausted all effective and practical remedies.

Let’s suppose, though, that failure to seek comprehensive certainty review is taken into account in determining whether the taxpayer exhausted its remedies. There are many possibilities, but let’s focus on two scenarios.

The first is that the position asserted by the jurisdiction results in an increase or decrease in the group’s foreign tax liability. Assume that the taxing jurisdiction asserts a claim that would result in an increase in the group’s overall tax liability (size of amount A). Because this involves amount A, and the United States could also be a market country getting a cut of amount A, this raises the possibility that the United States could be affected as both a source country and as a residence country. The noncompulsory payment rules, being part of the FTC limitation rules, are premised on the concept that an increase in foreign tax liability results in a decrease in U.S. tax. It is unclear how the taxpayer should take into account this potential increase or decrease in U.S. primary tax jurisdiction as a result of the noncompulsory payment rules. Given the focus of this article, we will treat this issue like one of those strange figures in a Bosch painting: interesting to contemplate but seemingly independent from all the actions going on in the rest of the picture leaving it difficult to see how it fits in.

If the assertion by the tax authority results in a net increase in foreign tax liability for the taxpayer, then the situation would appear to be one the noncompulsory payment rules in general, and the exhaustion of remedies requirement in particular, were designed to address. The taxpayer may need to demonstrate that the costs of seeking comprehensive certainty review were likely to exceed its expected benefits.

The second scenario is that the position asserted by the jurisdiction does not materially change overall tax liability but shifts it from one foreign jurisdiction to another or from one group member to another. This time, assume that the assertion by the tax authority would result in an increase in the taxpayer’s foreign tax liability to that jurisdiction but a decrease in the taxpayer’s (or another group member’s) tax liability to one or more other jurisdictions. In this latter case, should the noncompulsory payment rules consider only the changes in foreign tax liability that would take into account the taxpayer’s (or another group member’s) U.S. FTC? Does it matter whether (or when) the other jurisdictions make conforming changes to the taxpayer’s (or the other group member’s) tax liability? Whatever the policy and theoretical justifications may be for broad application of the noncompulsory rules, administrative and compliance concerns should drive this decision to some kind of carveout regarding changes in group tax liability, similar to carveouts provided by the regulations for consolidated groups and anti-hybrid rules.

If one concludes that failure to seek any of the reviews discussed above counts against the taxpayer for determining exhaustion of remedies, does that extend to failure to complete the entire process (for example, through a determination panel or its equivalent)? That seems to be the logical result of that conclusion, and if that is the case, the potential cost of the entire process should be weighed in determining the cost-effectiveness — and therefore the practicality — of pursuing the review.

Dispute Resolution

The dispute prevention measures in pillar 1 are just proposals right now, but the expected dispute resolution measures for the new pillars 1 and 2 taxing rights, like the dispute prevention measures in the public consultation document, would rely on currently available means of dispute resolution, either in practice or as a base. Without the creation of new dispute resolution measures, the taxpayer would be limited to measures available under domestic law and existing tax treaties. For example, “Treatment of ‘Related Issues’ in Part III” appears to follow the normal bilateral competent authority approach. Dispute resolution in that case would appear to be addressed in the existing language of reg. section 1.901-2(e)(5) (failure to pursue the mutual assistance process generally and a request for a dispute resolution panel specifically could result in the tax being considered noncompulsory). For new pillar 2 taxing rights, without a multilateral agreement, dispute resolution would need to follow the normal bilateral competent authority approach.

In that regard, some thought must be given to the role a mandatory arbitration provision plays in the analysis of whether the taxpayer pursued sufficient dispute resolution measures to exhaust its remedies under foreign law. Mandatory arbitration is often pitched as the cure to resolution of mutual agreement process disputes, but its value has always struck me as more relative than real.

There are significant limitations on its availability; for example, most treaties (at least U.S. ones) do not allow all disputes to go to arbitration, either because they are not within the scope of the arbitration provision (the arbitration provision lists specific disputes available for arbitration) or because the treaty permits the competent authorities to agree to exclude a matter from arbitration. Further, even if arbitration of a provision were assured, the price of MAP (including arbitration) may not be cost-effective given the size of the potential dispute. While having a mandatory arbitration provision is clearly better than not having one, its existence complicates rather than solves the analysis for whether the taxpayer has exhausted its remedies, if only because it introduces one more variable into the analysis.

Thus, proposals in pillars 1 and 2 to increase the availability of mandatory arbitration do not raise new issues about whether a taxpayer has exhausted its remedies. As is the case with existing treaties with mandatory arbitration provisions, however, the possibility of mandatory arbitration (and its additional cost) must be considered in evaluating whether the taxpayer has met the requirements of reg. section 1.901-2(e)(5)(v). That is one more complication to the analysis, but complexity and uncertainty are endemic to the FTC regulations, both now and once they are revised to deal with whatever gets adopted as part of the pillars 1 and 2 deliberations. Just think of it as one more strange Bosch painting creature, tormenting a poor soul, that you have to figure out.

Conclusion

The question whether a taxpayer has adequately used the dispute prevention and resolution tools available to it arises under the existing noncompulsory payment rules. However, the rules on exhaustion of remedies are premised on the interactions of the taxpayer with a single tax authority. The regulations do refer to MAP, which would presumably bring in a second tax authority, but MAP in a bilateral tax treaty may not be a good guide here.

In the case of MAP, the taxpayer expects a favorable, or at least neutral, outcome compared with forgoing MAP. In other words, in a bilateral treaty context, the taxpayer should wind up in no worse situation (other than costs incurred to pursue MAP) than it would be if it had not pursued MAP. But if the taxpayer seeks comprehensive certainty review, it could wind up paying more overall tax than it intended to show on its return because of tax liability being moved from lower-tax to higher-tax jurisdictions.

This possible shifting of tax liabilities among jurisdictions, especially foreign tax jurisdictions, suggests a need to revisit the rationale for the exhaustion of remedies requirement, at least in a multijurisdictional context. Current rules effectively assume that any additional foreign tax would be borne by the U.S. fisc because it would increase the taxpayer’s FTC. But what if this is really a dispute between foreign countries, with the United States recognizing their right to tax? Do the compulsory payment rules kick in only if the tax base moves from a lower-tax to a higher-tax country and simply not apply if the tax base moves the other way?

Regardless of what happens with the implementation of pillars 1 and 2, multijurisdictional disputes are increasingly going to be an issue for taxpayers. If the issues and methods of dispute resolution are going to evolve over time, so must the exhaustion of remedies requirement and other aspects of the noncompulsory payment rules.