The IRS’ new foreign tax credit regulations emphasize the substantial conformity of principles used to calculate the bases of the foreign and US tax. These principles were introduced in the proposed regulations via a so-called jurisdictional nexus requirement, which was manifested in the new regulations by way of novel income attribution requirements for royalty.
Assuming all other requirements are met, the imposition of a foreign tax on royalty income is creditable to US tax obligation if the foreign country’s sourcing rules are reasonably similar to the US sourcing rules under the tax code.
In the US, the source of royalty income from the use of intangible property depends on where the rights to the property are used. The right to use intangible property is traditionally derived from legal protections in property; accordingly, the location of use is historically derived from the country where the intangible property was registered and protected.
However, revenue rulings and Tax Court decisions make clear that the term “use” isn’t necessarily equivalent to place of registration and legal protection. Instead, various principles concerning the actual use of intangible property—including location of commercial exploitation, further development, and sale—must be considered when determining where intangible property is used or has a right to be used under US law.
A US taxpayer is seemingly eligible for a foreign tax credit only if a tax arises from royalties being sourced in a foreign country because of the use of, or right to use, intangible property. Under such circumstances, a foreign country’s sourcing rules, if based on location of use, may appear to be reasonably similar to US sourcing rules.
Under Treas. Reg. 1.901-2(a)(1)(iii), however, a foreign levy that is treated as an income tax under a relief from double taxation article of an income tax treaty, entered into between the US and foreign country imposing the levy, is deemed to be an income tax under the new regulations regardless of this attribution rule application as long as the taxpayer properly elects the treaty benefit.
Unfortunately, the coordination with treaties clause only deems the amount subject to relief under an income tax treaty as an income tax. If an income tax treaty doesn’t provide relief for a specific amount of income tax paid on royalty income, then a US taxpayer will only be eligible for the foreign tax creditif the sourcing-based attribution and other requirements are met.
This is evidenced in the plain language of Treas. Reg. 1.901-2(a)(1)(iii) and in Example 4 of Treas. Reg. 1.903-1(d). This example provides that any portion of royalty income unmodified by a US and foreign country income tax treaty must meet the new sourcing-based attribution requirement as the coordination with treaties clause is unable to be used.
Accordingly, some taxpayers who remit a royalty-derived foreign income tax to a foreign country that is a treaty partner of the US must still make an attribution rule determination. This may be particularly difficult if the foreign country has a sourcing rule that seems similar but has marked differences in comparison to US sourcing rules for royalties.
It will be interesting to see how the new regulations, particularly in terms of royalty income, will play out considering new developments of South Korea’s royalty sourcing tax laws. Under Article 6 of the United States-Republic of Korea Income Tax Convention, the parties adopted the same royalty sourcing principle, which provides that a royalty is sourced within a treaty country only if paid for the use of, or the right to use, such property within the treaty country.
For decades, however, royalty sourcing rules under the treaty have been actively challenged in Korean courts. The Supreme Court of Korea initially found that the place of use is predicated upon the place of registration. (See Supreme Court of Korea, 1991 NU 6887 [May 12, 1992].) This position was further upheld in follow-up cases. (See Supreme Court of Korea, 2012 DU 18356 [Nov. 27, 2014]).
Under such circumstances, US taxpayers who received royalties in South Korea, with respect to unregistered intangible property rights used in South Korea, didn’t have to pay any Korean taxes on such royalties under the treaty (or South Korea’s domestic law) as the royalties were deemed not sourced in South Korea due to having been derived from unregistered, therefore theoretically unused, property rights.
To confront this interpretation, the legislature took action to remove such preferential application of an income classification by way of Article 28 of the Adjustment of International Tax Act, which provides that the treaty overrides South Korea’s domestic laws.
The Supreme Court of Korea also narrowed the applicability of its past rulings, which focused on the location of registration, to only encompass legally defined rights overseas, such as patents registered overseas. (See Supreme Court of Korea, 2018 DU 36592 [Feb. 10, 2022].) Per recent case law, South Korea’s National Tax Service has legal grounds to assess Korean tax on royalty income derived from legally defined but unregistered rights, such as any copyrights, goodwill, and know-how, as long as the location of use for such legally defined but unregistered rights are found in South Korea.
Although the treaty has the same royalty sourcing rules as the code, South Korea’s domestic tax laws—particularly those related to royalty sourcing rules—have evolved in some instances. They’re on the brink of evolving in others, from South Korea’s long-standing location of use rules to location of payment principles.
Under such circumstances, will a US taxpayer earning royalties in South Korea from legally defined but unregistered property rights be entitled to the foreign tax credit—considering new Korean laws that may technically source royalties at the location of use still but which, in effect, equate location of use with location of payment? If the IRS argues the foreign tax credit is unavailable, it will signal a hard-line application of the rule under the new regulations.
The IRS ideally would publish a list of countries deemed to have reasonably similar sourcing rules in terms of the new sourcing-based attribution requirement. The proposed regulations the IRS released in November add some exceptions for royalties derived from a single country license under which payment is made with respect to the part of the territory of the license that is solely within the foreign country imposing the taxes. But they’re far from sufficient to alleviate taxpayer concerns.
Do the new proposed regulations signal that the attribution rule will be flexibly applied under a facts and circumstance test as long as the foreign government has a primary taxing right over the royalty income? If so, are the proposed regulations intended to illustrate a new test for the sourcing-based attribution rule?
If not, is this a limited exception based on circumstances where a location of use sourcing rule is met regardless of the type of sourcing rule used in the foreign jurisdictions? It looks like taxpayers will continue to have cause to worry and question how similar is similar enough.
Josh Portman, a member of B.J. Kang Law, PC, made substantial contributions to this article.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Byoung Jo Kang is a business lawyer with expertise in US income taxation and often represents domestic and international businesses, families, and individuals. He also represents foreign biotech, life sciences, and health-care companies and their executives.
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