KPMG Warns That Proposed FTC Regs Would Result in Double Taxation

January 23, 2023

Internal Revenue Service
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: IRS: REG-112096-22: Regulations Relating to the Foreign Tax Credit

Sir or Madam:

KPMG LLP (“KPMG”) appreciates the opportunity to submit comments on the proposed regulations relating to the foreign tax credit, issued November 22, 2022. Specifically, these comments relate to the effect on individual taxpayers of these regulations and more generally the final regulations as published in the Federal Register on January 4, 2022.

KPMG, the audit, tax and advisory firm, is the U.S. member firm of KPMG International Cooperative (“KPMG International”), which is a global network of professional firms providing audit, tax and advisory services. KPMG International operates in 152 countries and has approximately 189,000 people working in member firms around the world.

KPMG's Global Mobility Services practice files a significant number of U.S. income tax returns each year for individuals who are on international employment-related assignments either inbound to, or outbound from, the United States and who comprise U.S. citizens, U.S. residents, and U.S. nonresidents. Many of these returns include Form 1116 Foreign Tax Credit (Individual, Estate, or Trust). In addition, the non-U.S. member firms of KPMG International file individual U.S. income tax returns, many of which include Form 1116. Thus, while KPMG has numerous clients on whose behalf it prepares income tax returns involving foreign tax credits, these comments are not submitted on behalf of any client.

1 Background

On November 12, 2020, the Treasury Department and the IRS published proposed regulations (the “2020 FTC proposed regulations”),¹ addressing changes made by the Tax Cuts and Jobs Act² and other foreign tax credit issues. The 2020 FTC proposed regulations were finalized on January 4, 2022 (the “2022 FTC final regulations”).³ Correcting amendments to the 2022 FTC final regulations were published on July 27, 2022,⁴ and further proposed regulations were published on November 22, 2022 (“the 2022 FTC proposed regulations”).⁵ The 2022 FTC proposed regulations address various issues raised by the 2022 FTC final regulations that principally affect corporate taxpayers, but do not address certain specific issues that directly affect individual income taxpayers. As stated in the Special Analyses accompanying the 2022 FTC final regulations, the number of Form 1116s filed by individuals vastly outnumbers the number of Form 1118s filed by C corporations: by 9.3 million to 17,500 in tax year 2018.⁶ This disparity emphasizes the importance of addressing the impact of the changes introduced by these regulations on affected individuals, some of whom could face the loss of foreign tax credits that were previously available to them.

The 2020 FTC proposed regulations expressly acknowledge that the fundamental purpose of the foreign tax credit is to “mitigate double taxation of income that is attributable to a taxpayer's activities or investment in a foreign country.”⁷ In addition, one stated intent of the 2020 FTC proposed regulations was to “simplify and clarify” the application of the rules in relation to the net gain requirement.⁸ However, these regulations as currently drafted will, in practice, have the opposite effect in that in many cases they will result in double taxation of individuals, and in all cases they introduce an unprecedented degree of complexity and confusion to the process of claiming foreign tax credits on Form 1116.

The 2022 FTC final regulations require all individual taxpayers (and/or their advisers) who have activities or investment in a foreign country to determine separately for each foreign levy to which they may be subject, whether that levy meets each of the four tests (realization, gross receipts, cost recovery, and attribution) to qualify as a net income tax under section 1.901-2(a)(3),⁹ and potentially requires all affected individual taxpayers (and/or their advisers) to determine whether a levy that does not qualify as a net income tax is a tax paid in lieu of a tax on income under section 1.903-1(b). This places a huge and unreasonable burden on these individuals and their advisers in that it requires them to obtain a detailed familiarity with foreign tax laws and their application to determine if they meet each of these criteria.

In addition to foreign language issues, there are professional practice issues for U.S. tax advisers who are not licensed to practice in foreign jurisdictions and are therefore not qualified to advise on the meaning and effect of foreign tax laws for this purpose.

There are also severe time constraints. The 2022 FTC final regulations are effective for tax years beginning on or after December 28, 2021 and therefore apply to individual taxpayers who (with their advisers) are currently starting to prepare tax returns for calendar year 2022. At present, the Instructions for Form 1116 only make passing reference to the 2022 FTC final regulations and do not provide guidance to individuals as to how these regulations impact their foreign tax credit.¹⁰

If individual taxpayers are no longer entitled to foreign tax credits on their 2022 income tax returns, which they have been entitled to in prior years, because the foreign levies in question no longer meet the definition of a foreign income tax in section 1.901-2(a)(1)(ii), this will result in unrelieved double taxation for such individuals and, in relation to their U.S. income tax liability, the risk of significant underpayment penalties. In addition, where employers and other withholding agents have calculated withholding amounts on wages and other income paid during 2022 based on anticipated eligibility for foreign tax credits that are no longer available, this could result in significant underwitholding for affected taxpayers.

The following sections identify specific issues with the 2022 FTC final regulations in relation to the cost recovery requirement, the attribution requirement, the withholding exception for wages subject to legally required foreign income tax withholding, and the treaty coordination rule, and makes proposals as to how these specific issues could be addressed. However, to permit time for these issues to be addressed, and to alleviate the severe time constraints referred to above, we respectfully suggest that the effective date of the 2022 FTC final regulations be suspended for 12 months for individual taxpayers so that these new requirements are not imposed in relation to 2022 individual tax returns.

2 Cost recovery

The regulations provide that “[a] foreign tax is considered to permit recovery of significant costs and expenses even if the foreign tax law does not permit recovery of any costs attributable to wage income or to investment income that is not derived from a trade or business.”¹¹ This language was added in recognition that “the Code contains various limitations on the recovery of non-business expenses that have been modified from time to time.”¹²

On its face, this exception appears to be intended to ensure that a levy imposed by a foreign country on the wage income of a U.S. citizen living or working in that country will satisfy the cost recovery requirement. If a foreign country assessed a levy only on wage income, this result would be achieved. However, few countries have a separate levy imposed on wage income alone. Many countries take an approach similar to the United States, assessing tax on a taxable base of combined income. Under these regulations, this tax on combined income would be viewed as a single levy.¹³ This determination as to what constitutes a separate levy is largely unchanged from prior regulations.¹⁴ However, the significance of the separate levy determination is of greater importance under these regulations. Whereas under prior law the “predominant character” analysis allowed taxpayers to overcome minor differences in taxing principles, the cost recovery requirement adopts an “all or nothing” approach.

Notwithstanding that a U.S. citizen may only have gross receipts attributable to employment in a foreign country, the regulations provide that if, under the tax laws of that foreign country, this wage income would be combined with income from other sources if the U.S. citizen had income from other sources, and a standard deduction or general allowance is applied against this combined income to arrive at taxable income, the tax on this combined income is a separate levy and must permit recovery of significant costs and expenses attributable to gross receipts from non-employment sources.¹⁵ If the foreign tax law disallows any single “per se” significant cost or expense,¹⁶ and this disallowance is inconsistent with any principles underlying the disallowances required under the Internal Revenue Code, the entire foreign levy (including the portion attributable to wage income) does not satisfy the cost recovery requirement and is potentially not a creditable foreign income tax.

This may be the intended result of these regulations but seems overly punitive when applied in the context of a U.S. citizen working in a foreign country whose only source of income is wage income that, but for a standard allowance applied against a theoretical tax base, would otherwise satisfy this requirement. Additionally, the requirement to perform this analysis places an unreasonable burden on an individual (or the individual's U.S. tax services provider), who must now consider all theoretically possible outcomes under the tax laws of a foreign country and must determine if this requirement is satisfied. This presumes access to reliable, translated resources, and requires individuals or their U.S. tax advisers to interpret complex tax codes that they are not licensed or qualified to advise on.

For example, consider Brazil, which has both a corporate income tax (“CIT”) levy and an individual income tax (“IIT”) levy. Brazil's CIT rate is lower than the IIT, and it is seemingly easy to form a corporation in Brazil. Brazil's IIT is assessed on a Brazil resident's worldwide income. Employment income, self-employment income (sole proprietorship), royalties, and income from immovable property are combined into one taxable base, and the IIT assessed would be a separate levy under the regulations.

While specific deductions are permitted in relation to each income type, common personal deductions and allowances are applied against the sum of net income. The personal deductions and allowances are not specific to any one income type. Losses in one category can only reduce gains in the same category, but not below zero (e.g., a loss attributable to self-employment activities would not reduce income from employment or gain from the sale of real property).

Limited or no deductions are available against employment income and royalties, but Brazil resident individuals are allowed to deduct expenses incurred in connection with self-employment and rental activities. However, deductions for capital expenditures, such as buildings, machinery, and equipment are limited. Specifically, a deduction for depreciation is disallowed in its entirety. Additionally, while deductions for rents are allowed, expenses related to finance lease agreements are not.

Given these limitations, Brazil residents with self-employment income or sole proprietorships will typically incorporate, as these deductions are fully permitted without limitation for corporate entities and the CIT is lower than the IIT.

In applying the cost requirement to Brazil's IIT, even though it is uncommon for a Brazil resident to subject gross receipts from their self-employment or sole proprietorship to Brazil's IIT, the 2022 FTC regulations require considering these gross receipts in the separate levy analysis on the grounds that these amounts could theoretically be subject to Brazil's IIT. Because these gross receipts would be part of the same combined tax base as wage income, the disallowance of depreciation or leasing expenses (per se significant costs or expenses) against these gross receipts may lead a non-Brazil tax professional to conclude that the entire levy fails the cost recovery requirement.¹⁷ It would take a significant investment of time and expertise for an individual to gain sufficient understanding of the Brazil IIT to determine whether it allows for alternative ways to recover any deductions for capital expenditures.

To give a sense of the complexity and expense this determination under the regulations requires of individuals, the above understanding of the Brazil IIT is based on a large amount of research and an ongoing, months-long conversation with several Brazil tax and legal experts. This is not “readily available information,”¹⁸ and is an onerous financial and administrative burden to impose on individual U.S. citizens living and working in a foreign country who are being double taxed on their employment income. An alternative would be for the individual or their U.S. tax adviser to attempt to review and interpret Brazil's tax laws, which they are not licensed or qualified to advise on, assuming they are able to locate a reliable translation of Brazil's law or can read and understand Portuguese. This a great deal of subjective analysis for a requirement intended to provide a “more objective” approach to the creditability analysis.¹⁹

But the analysis does not end there. If it is determined that the disallowance of depreciation and leasing expenses is not consistent with U.S. principles (which is potentially the case), and assuming Brazil's IIT satisfies the arm's length standard (which it does not, see discussion in part 3.1 below) a U.S. citizen would be left trying to determine whether Brazil's CIT, a tax an individual may not be subject to or have any experience with, satisfies all of the net income tax requirements. This analysis would need to be undertaken to determine whether the IIT satisfies the definition of a tax in lieu of a tax on income so that the U.S. citizen may claim a foreign tax credit with respect to the Brazil IIT assessed on the U.S. citizen's employment income with respect to services performed in Brazil. Thus, in addition to becoming a Brazil IIT tax expert, the regulations require the individual, or the individual's U.S. tax adviser, also become Brazil CIT tax experts.

The end result of this analysis for Brazil's IIT is that a U.S. citizen or resident living and working in Brazil, whose only source of income subject to Brazil's IIT is wage income, will potentially be denied a foreign tax credit and will be double taxed on this employment income, because Brazil has a standard deduction that applies to a combined income tax base. Although this example focuses on Brazil's IIT, it seems reasonable to assume that, like the United States, other foreign countries levy an individual income tax on the combined income of an individual and allow for general deductions against this combined tax base. Without a thorough review of every single country's tax law, it is impossible to determine whether a specific country's individual income tax regime satisfies the cost recovery requirement, and difficult to determine whether a particular disallowance provided under a foreign country's law is consistent with any principle reflected in the Internal Revenue Code.

Proposal: Although the regulations appear to acknowledge the accepted U.S. and international tax principle that a country has a right to tax an individual's remuneration for services performed within that country,²⁰ and appear to except wage income earned by an individual from the cost recovery requirement,²¹ in practice the regulations will deny a U.S. citizen who lives and works in a foreign country a foreign tax credit with respect to foreign taxes imposed on wage income earned in that foreign country. The cost recovery requirement as written will mean U.S. citizens living or working in certain countries will be subjected to double tax with respect to employment income earned for services performed in that country. This is not an equitable result and is inconsistent with U.S. taxing principles.

The Treasury and the IRS should consider re-adopting the predominant character analysis for levies imposed on individuals. Alternatively, in instances where the cost recovery requirement is not met because of the application of a standard deduction or general allowance against a combined tax base, the Treasury and IRS should consider allowing an individual to allocate on a pro rata basis the total tax assessed on the combined income to wage income and personal investment income (income types excepted from the cost recovery requirement) and allow a foreign tax credit with respect to the foreign tax attributable to wage income and personal investment income.

3 Attribution requirement

3.1 Tax on residents

The 2022 FTC final regulations provide that “[t]he base of a foreign tax imposed on residents of the foreign country imposing the foreign tax may include all of the worldwide gross receipts of the resident.”²² However, the foreign tax law must provide that “any allocation made pursuant to the foreign country's transfer pricing rules” is determined “under arm's length principles.”²³

From the discussion in the preamble to the 2022 FTC final regulations, it seems Treasury and the IRS added this requirement out of a concern that, with respect to corporate profits, “many foreign jurisdictions have disregarded international taxing norms to claim additional tax revenue, resulting in the adoption of novel extraterritorial taxes.”²⁴ However, the preamble does not address whether Treasury and the IRS considered the impact this requirement would have on U.S. citizens living and working in foreign countries that do not adhere to the OECD's arm's length standard.

For example, Brazil does not presently adhere to the OECD's arm's length standard. Hence, a U.S. citizen resident in Brazil whose only income is wages subject to Brazil income tax will be subject to double tax because Brazil's transfer pricing rules are inconsistent with international principles and the entire Brazilian tax regime therefore fails this attribution requirement. This issue is not limited to Brazil, and potentially extends to any U.S. citizen living and working in a foreign country that does not adhere to the arm's length standard.

Proposal: The Treasury and IRS should consider adding a provision to the attribution requirement that exempts any portion of a levy assessed on wage income and personal investment income of an individual from this transfer pricing allocation requirement.

3.2 Tax on nonresidents

The preamble to the 2022 FTC final regulations, in justifying the addition of its attribution requirements to the definition of a foreign income tax, states that “[a]bsent this rule, U.S. tax on net income could be reduced by credits for a foreign levy whose taxable base was improperly inflated by unreasonably assigning income to a taxpayer. . . . ”²⁵ It should be noted that the definition of “resident” as used in the 2022 FTC final regulations considers “citizenship” as an acceptable criterion by which a country may subject an individual to worldwide taxation. The United States is one of the only countries that impose tax on the worldwide income of their citizens, regardless of where those citizens actually reside and regardless of whether those citizens have income from activities, sources, or property within their country of citizenship. Notwithstanding “the principle that U.S. tax principles, not varying foreign tax law policies, should control the determination of whether a foreign tax is an income tax . . . is eligible for a U.S. foreign tax credit,”²⁶ from the perspective of the rest of the taxing world, imposing tax on the basis of citizenship alone is viewed as extraterritorial, which is why the availability of a foreign tax credit is of great import to U.S. citizens living and working outside the United States. The existing regulations relating to the foreign tax credit limitation under section 904 already ensure that the foreign tax credit is not subsidizing foreign jurisdictions at the expense of the United States with respect to U.S. persons living and working overseas. As such, we do not think that the attribution requirements in this context, when U.S. citizens are living and working abroad, are necessary to ensure the policy concerns that Treasury and the IRS were trying to address.

The 2022 FTC final regulations generally acknowledge a foreign country's authority to tax the worldwide income of its residents.²⁷ However, the 2022 FTC final regulations define “resident” and “nonresident” of a foreign country by reference to the foreign country's basis for imposing income tax on the individual. An individual is a resident of a foreign country “if the individual is liable to income tax in such country by reason of the individual's residence, domicile, citizenship, or similar criterion under such country's foreign tax law.”²⁸ An individual is a nonresident of a foreign country if the individual is liable to income tax in a foreign country by reason of a criterion other than “residence.”²⁹ These definitions are significant in that the 2022 FTC final regulations provide that a foreign levy imposed on nonresidents is always treated as a separate levy from that imposed on residents,³⁰ and the attribution requirement that applies to a foreign levy imposed on nonresidents of a foreign country must satisfy strict jurisdictional nexus requirements that do not apply to a foreign levy imposed on residents of a foreign country.³¹

The rules and definitions described above combine to lead to incongruous and unfair results. In particular, if Individual A resides in Country X, which taxes its residents on a world-wide basis, then Individual A can claim a US foreign tax credit for Country X taxes on income earned anywhere in the world. In contrast, if Individual B resides in Country Y, which taxes its inhabitants (and its non-residents) on the basis of source, but has a sourcing rule that materially differs from U.S. tax principles (for example, by including in the base all wages paid by an employer based in Country Y), then Individual B is entitled to no U.S. foreign tax credit at all — even if all of Individual B's income in fact arises from sources within Country Y as determined under U.S. principles. It is difficult to conceive of a policy rationale under which Country Y's more constrained assertion of taxing jurisdiction when compared to Country X should end up so severely disadvantaging Individual B relative to Individual A, and is inconsistent “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 income. See Bowring v. Comm'r, 27 B.T.A. 449, 459 (1932) ('In the case of the citizen and resident alien, the United States recognizes the primary right of the foreign government to tax income from sources therein . . . and accordingly, grants a credit.').”³²

For example, consider Hong Kong (SAR) (hereinafter “Hong Kong”). Hong Kong operates a territorial system and assesses “[S]alaries tax . . . on every person in respect of his income arising in or derived from Hong Kong from the following sources — (a) any office or employment of profit; and (b) any pension.”³³ An individual's “residence, domicile, citizenship, or similar criterion” under Hong Kong's foreign tax law does not affect the imposition of salaries tax, and therefore any individual subject to salaries tax is a “nonresident” under the 2022 FTC final regulations.³⁴

Applying the net income tax requirements to the salaries tax, the realization, gross receipts, and cost recovery requirements appear to be satisfied, given the exception to the cost recovery requirement provided to wage income under section 1.901-2(b)(4)(i)(C)(2). However, because the salaries tax is with respect to all individuals subject to the levy a “foreign levy imposed on nonresidents” under the 2022 FTC final regulations, it is necessary to consider whether it satisfies any of the attribution requirements of section 1.901-2(b)(5)(i).

The attribution based on situs of property test is not applicable as the salaries tax is not assessed on gain from the disposition of property.³⁵ The income attribution based on activities test does not appear to be satisfied, given that the salaries tax takes “into account as a significant factor” a destination-based criterion (i.e., Hong Kong employment).³⁶ Nor does it appear the income attribution based on source test is satisfied, as under Hong Kong tax law, gross income from services is not sourced on where the services are performed, but rather sourced based on whether an individual has Hong Kong employment.³⁷

It therefore appears that the Hong Kong salaries tax may potentially fail to be a “foreign income tax” for purposes of 901.³⁸ If it is determined to fail the attribution requirement of section 1.901-2(b)(5), it would also not appear to satisfy either the jurisdiction to tax excluded income requirement of section 1.903-1(c)(1)(iv) or the source-based attribution requirement of section 1.903-1(c)(2)(iii) and is potentially not a “tax in lieu of an income tax” for purposes of section 903. It appears that the 2022 FTC final regulations will deny a foreign tax credit to U.S. citizens who live and work in Hong Kong and pay salaries tax, with the result that these U.S. citizens will be subjected to double taxation on their income earned in Hong Kong.

This issue is not limited to Hong Kong. U.S. citizens living and/or working in countries such as Angola, Guatemala, Honduras, Nicaragua, Panama, and Paraguay could also be subject to double taxation on remuneration for services performed within these jurisdictions because these countries adopt a territorial system and source service income inconsistent with U.S. principles.³⁹

Proposal: As written, the source-based attribution test may subject U.S. citizens living or working in these countries to double-taxation. Although these attribution requirements may ensure the United States is not subsidizing a foreign country's corporate tax regime, this concern would not seem to extend to a foreign country's individual income tax regime given the foreign income tax limitation that applies to individuals with respect to employment income already limits the credit to foreign income tax assessed on foreign-source general category amounts. The Treasury and IRS should consider exempting wage income of an individual from the source-based attribution requirement as it did with respect to the cost recovery requirement⁴⁰ to ensure U.S. citizens living and working abroad are not needlessly subjected to double taxation on their remuneration for services performed outside the United States.

Alternatively, if the Treasury and the IRS are concerned that the foreign tax credit limitation is not sufficient to protect U.S. tax on net income against a foreign levy assessed on an inflated tax base, instead of denying a foreign tax credit to an individual in its entirety, the Treasury and IRS could limit the amount of foreign tax paid or accrued to a specific country available for credit to amounts allocable to gross receipts from activities, sources, or property within such foreign country, as determined under U.S. principles. Such an approach would ensure that an individual's foreign tax credit limitation with respect to an inflated foreign tax amount does not consider income from other jurisdictions and would prevent an individual from potentially benefitting from the inflated foreign tax through the excess foreign tax credit carryback and carryforward rules. However, before considering such an approach the Treasury and the IRS should be mindful that the existing foreign tax credit limitation rules presently help to ensure that U.S. citizens living or working overseas are not subject to double taxation due to timing differences between the U.S. and the foreign country's tax systems, and that the potential for individuals, particularly employees (who generally have limited control over where services are performed), to engage in any sort of abusive cross-crediting is limited.

As another alternative, if the Treasury and the IRS believe that repealing this requirement as applied to individuals may allow for some sort of abuse not addressed by the foreign tax credit limitation, it should consider defining the term “resident” in a manner other than solely by reference to a foreign country's basis for imposing income tax. For example, section 1.901-2(g)(6)(i) could be rewritten to provide as follows:

An individual is a resident of a foreign country if the individual is a tax resident of such foreign country (liable to income tax in such country by reason of the individual's residence, domicile, citizenship, or similar criterion under such country's foreign tax law), or a deemed resident of such foreign country (has substantial presence, is domiciled in, or would satisfy the qualified individual definition (as defined in section 911(d)) with respect to such foreign such country.

Such a revision would ensure inhabitants of territorial systems are treated in the same manner as inhabitants of resident-based systems under the 2022 FTC final regulations. However, if Treasury and the IRS adopt a “deemed resident” concept akin to the above, consideration should be given to the treatment of multi-year compensation arrangements where an individual may be a deemed resident at grant but a nonresident at vest, given the jurisdictional nexus issues presented by territorial tax systems.

4 Withholding exception for wages subject to legally required foreign income tax withholding

Because U.S. citizens are subject to Federal income tax on their worldwide income,⁴¹ employers of U.S. citizens are generally required to report as wages all amounts paid for services performed by U.S. citizens,⁴² and are generally required to withhold Federal income tax from those wages,⁴³ subject to limited exceptions.⁴⁴ A U.S. citizen who is on an international assignment in a foreign country, or otherwise lives and works in a foreign country, is also generally subject to income tax withholding in that foreign country.

Requiring an employer to withhold income tax on wage income in two countries presents payroll challenges and administrative burdens to the employer. Additionally, subjecting a U.S. citizen to withholding in two countries presents a significant cashflow burden to the U.S. citizen. Fortunately, an exemption from withholding is available with respect to amounts paid to a U.S. citizen employee for services performed in a foreign country (or U.S. possession) that are subject to legally required foreign income tax withholding.⁴⁵ However, to qualify for this Federal income tax withholding exemption, amounts withheld from an employee's salary under foreign law must be “income taxes” creditable by the employee under section 901.

For the reasons set out above, the FTC 2022 final regulations as written will cause certain foreign withholding taxes to no longer be creditable foreign income taxes. However, the Treasury and Internal Revenue Service has not provided to employers or U.S. citizens a list of countries whose income taxes are no longer creditable. Employers may be relying on an exception no longer available to them, potentially underwitholding Federal income tax and unintentionally subjecting themselves and their employees to underpayment penalties.

5 Treaty coordination rule

The 2022 FTC final regulations, as corrected by correcting amendments published on July 27, 2022,⁴⁶ include at section 1.901-2(a)(1)(iii) a treaty coordination rule that provides (in part) as follows:

A foreign levy that is treated as an income tax under the relief from double taxation article of an income tax treaty entered into by the United States and the foreign country imposing the levy is a foreign income tax if the levy is, as determined under such income tax treaty, paid by a citizen or resident of the United States that elects benefits under the treaty.

This provision was not included in the 2020 FTC proposed regulations but was added to the 2022 FTC final regulations in response to comments received concerning the interaction between income tax treaties and U.S. domestic foreign tax credit rules.⁴⁷ The effect of the treaty coordination rule is that a U.S. taxpayer is not required to demonstrate that a foreign levy is either a net income tax as defined in section 1.901-2(a)(3) or a tax in lieu of an income tax as defined in section 1.903-1(b) provided it is an income tax under the relief from double tax article of an applicable income tax treaty.

The policy underpinning this rule appears to be that income taxes imposed by foreign countries that have entered into income tax treaties with the United States can generally be presumed to be income taxes “in the U.S. sense” and are therefore in conformity with the overriding purpose of the revisions to the foreign tax credit regulations, which is to ensure that foreign levies should, in their essential characteristics, be similar to U.S. income taxes in order to be creditable.⁴⁸ As a result, they are not subject to the four-part net gain analysis imposed by section 1.901-3(b).

However, because the treaty coordination rule is not more expansive individual taxpayers may still need to apply the new foreign tax credit rules to foreign individual income taxes that would result in significant additional complexity and potential exposure to double tax or other unintended consequences.

A limitation of the treaty coordination rule is the requirement that, to claim the benefit of this rule, a U.S. citizen or resident individual must “elect[ ] benefits under the treaty.” This requirement could prove problematic and costly for some individuals living in treaty countries because there are certain situations in which it is either unnecessary (prior to these regulations) or positively disadvantageous for such individuals to claim the benefits of the income tax treaty between the United States and a foreign country.

These problems are illustrated by the following example:

Example: Taxpayer A is a lawful permanent resident of the United States (green card holder) who lives and works in France, where she is an income tax resident. All of her income is from wages for personal services performed in France. Because she is a resident of both the United States and France under their respective domestic rules, she must, if she wishes to claim any benefits under the U.S.-France income tax treaty, apply the tie-breaker provisions of article 4, paragraph 4.⁴⁹ Assuming the tie-breaker tests result in her being treated as a resident of France and a nonresident of the United States, this could cause her to be liable to the expatriation tax under section 877A if she meets the definition of a covered expatriate.⁵⁰ The cost to her of the expatriation tax liability might outweigh the benefit of being able to rely on the treaty coordination rule. Hence, if she wishes to claim foreign tax credits on her U.S. income tax return in relation to the French tax paid or accrued on her French source wage income, it appears that she and her advisors must separately evaluate each French levy for compliance with the net income tax requirements of section 1.901-2(b). In this case, having to learn about the foreign tax credit rules and then subsequently applying them to specific French taxes on her wage income would result in increased complexity.

Proposal: For individuals living and working in foreign countries that are treaty partners with the United States, the treaty coordination rule could be modified so as to permit such individuals to rely on the list of taxes covered in the relief from double tax article and treat such taxes as an income tax for purposes of applying the section 1.901-2 regulations as a simplification measure, regardless of whether they actually claim benefits under that article. This would reduce the complexity that individual taxpayers who live and work overseas otherwise face in applying this rule.

In addition, guidance should be provided as to whether reliance on the treaty coordination rule is disclosable pursuant to section 6114 and the regulations thereunder. If so, this could be achieved either by expressly requiring disclosure on Form 8833, or by adding a check box to Form 1116 for taxpayers to indicate that they are claiming the benefit of this rule. However, if the rule is viewed as a simplification measure under the section 901 regulations, the better view may be that the treaty itself is not invoked for purposes of a treaty-based claim, but that individual taxpayers who live and work overseas in treaty jurisdictions are able to rely on the treaty list of foreign taxes to treat the levy as a foreign income tax within the meaning of section 1.901-2. We do not think that the policy objectives of the regulations would be at risk by including this type of a rule.

We welcome the opportunity to discuss our comments further with any interested personnel at the Treasury Department and the IRS. Please feel free to contact any of: Martha Klasing at 202-533-4206; Seth Green at 202-533-3022; Quyen Huynh at 949-885-5400; Benedict Francis at 202-533-5708; Alex Strebel at 314-244-4303; or John Seery at 202-533-3313.

Very truly yours,

Martha A. Klasing
Partner, Washington National Tax
KPMG LLP
Washington, DC

cc:
Michael Plowgian, Deputy Assistant Secretary (International Tax Affairs);
Lindsay Kitzinger, Acting International Tax Counsel;
Deborah Tarwasokono, Attorney-Advisor, Office of the International Tax Counsel;
Melanie R. Krause, Acting Deputy Commissioner for Services and Enforcement;
Peter Blessing, Associate Chief Counsel (International);
Daniel McCall, Deputy Associate Chief Counsel (International);
Michael Gilman, Branch Chief, Office of the Associate Chief Counsel (International), Branch 3;
Laura Shi, Senior Technical Reviewer, Office of the Associate Chief Counsel (International), Branch 3;
Jeffrey Parry, Senior Counsel, Office of the Associate Chief Counsel (International), Branch 3