US | Technical corrections to foreign tax credit regulations offer relief from cost recovery rules and include other impactful changes

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EY Global

4 Aug 2022
Subject Tax Alert
Categories Corporate Tax
Jurisdictions United States
  • The technical corrections broaden the scope of permissible disallowances under the cost recovery requirement. More foreign tax credit guidance, however, is anticipated.

  • The technical corrections to the global intangible low-taxed income (GILTI) high-tax exclusion limit the foreign taxes taken into account for purposes of determining the effective rate of foreign tax on a tested income item.

  • Taxpayers planning to make the GILTI high-tax exclusion election may be required to recognize more tested income than they anticipated.

Executive summary

On 27 July 2022, the United States (US) Treasury Department published technical corrections (87 FR 45018, the Technical Corrections) to controversial final regulations (T.D. 9959, the Final Regulations) on foreign tax credits published on 4 January 2022. For an Alert discussing the Final Regulations, see EY Global Tax Alert, US foreign tax credit regulations revamp creditability rules for foreign income taxes and include several other key changes, dated 12 January 2022.

The Technical Corrections revise the cost recovery requirement, which is a key element of the Final Regulations' rules for determining the creditability of a foreign tax under Internal Revenue Code (IRC)[i] Section 901. The Technical Corrections also revise rules for allocating and apportioning foreign taxes paid or accrued with respect to certain sales of property that are disregarded for US federal tax purposes and limit the foreign taxes taken into account under the GILTI high-tax exclusion. The Technical Corrections represent the first round of changes to the Final Regulations, with additional relief expected in the coming months.

Detailed discussion

Creditable foreign income taxes

Section 901 generally permits a taxpayer to claim a credit against its regular US tax liability for "income, war profits, and excess profits taxes" paid or accrued during a tax year to any foreign country or US possession. Under prior Section 901 regulations, a foreign levy was treated as an income tax if: (i) the foreign levy was a tax; and (ii) the tax's character was predominantly that of an income tax in the US sense (the predominant character test). The predominant character test was generally met if the foreign tax was likely to reach net gain in the normal circumstances in which it applied (the net gain requirement).

The net gain requirement, in turn, was met if the foreign levy satisfied realization, gross receipts and net income requirements. The realization requirement was met if the foreign tax was imposed on or after a realization event in the US sense (or in certain instances, before a realization event); the gross receipts requirement was met if the foreign tax was imposed on the basis of gross receipts (or a proxy for gross receipts that was not likely to exceed gross receipts); and the net income requirement (renamed the "cost recovery requirement" in the Final Regulations) was met if the foreign tax law allowed for the recovery of significant costs and expenses (or provided a comparable allowance that equaled or exceeded those significant costs and expenses).

The Final Regulations significantly modified the requirements that a foreign tax must satisfy to be claimed as a credit in several respects, creating uncertainty as to whether many foreign taxes that were traditionally creditable under Section 901 continued to be creditable. One of the most problematic aspects of the Final Regulations was the revised cost recovery requirement, which was met only if a foreign tax law: (i) allows for the recovery of significant costs and expenses attributable to gross receipts in the foreign tax base; or (ii) permits recovery of an alternative amount that by its terms may be greater, but never less, than the actual amounts of significant costs and expenses. The Final Regulations provided a list of "per se" significant costs and expenses, including capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation. Given that this list was expansive, and that most countries limit one or more of the costs or expenses on it, the creditability of the taxes imposed by most foreign countries depended on whether those taxes satisfy a narrow and ambiguous exception.

Before being revised by the Technical Corrections, that exception provided that a foreign tax would not fail to satisfy the cost recovery requirement when the foreign tax law disallowed the recovery of certain costs and expenses, provided that such disallowance was "consistent with the principles underlying the disallowances required under the IRC, including disallowances intended to limit base erosion or profit shifting." Examples of permissible disallowances expressly sanctioned by the Final Regulations included limitations on interest deductions based on principles similar to Section 163(j) (based on "10 percent of a reasonable measure of taxable income"), disallowances based on anti-hybrid principles similar to Section 267A, and public policy-premised disallowances similar to those under Section 162.[ii]

This limited exception posed significant problems. Foreign countries' tax laws include numerous and varied disallowances and deferrals of deductions for costs and expenses, including limitations on the deductibility of interest, cross-border payments, stock-based compensation, and other items. In many cases, it is difficult to determine whether the limitation is consistent with the principles underlying one or more limitations in the Code.

Moreover, foreign tax laws that allow recovery of expenses but defer that recovery (for example, by providing tax basis, but not allowing the basis to be amortized) raised questions under the Final Regulations. In general, timing differences in the recovery of significant costs or expenses under foreign law do not preclude a foreign tax from satisfying the cost recovery requirement. However, the Final Regulations provided that "a foreign tax law permits recovery of significant costs and expenses even if such costs and expenses are recovered earlier or later than they are recovered under the Internal Revenue Code, unless the time of recovery is so much later (for example, after the property becomes worthless or is disposed of) as effectively to constitute a denial of such recovery." This language potentially suggested that basis recovery upon worthlessness or disposition of an asset — as opposed to immediate deductibility or amortization over time — could prevent a foreign tax from satisfying the cost recovery requirement. For example, many countries deny amortization deductions for purchased goodwill, going concern value, and other intangible assets, but permit recovery of the cost upon disposition or worthlessness, potentially implicating this timing restriction.

Technical corrections

As corrected, the cost recovery requirement now provides that the disallowance of all or a portion of certain costs or expenses is permitted so long as it is consistent with "any principle underlying the disallowances required under the [Code]," including "the principles limiting base erosion or profit shifting and public policy concerns." The replacement of "the principles" with "any principle" and the addition of "public policy concerns" broadens the scope of permissible disallowances under the cost recovery requirement. In addition, the technical corrections remove specific references to Sections 163(j) and 267A in the context of base erosion principles and more clearly state that a foreign tax will not fail the cost recovery requirement if it limits interest expense based on taxable income or disallows deductions under anti-hybrid rules. The Technical Corrections do not remove the reference to Section 162; however, they clarify that the disallowance of deductions based on public policy considerations similar to those "underlying the disallowances contained in [IRC S]ection 162" would not run afoul of the cost recovery requirement, reinforcing the fact that the cost recovery requirement entails a principles-based analysis and that disallowances under foreign law do not need to operate similarly to disallowances in the Code.

With respect to the timing of recovery, the Technical Corrections liberalize the rule by moving the parenthetical statement referring to worthlessness or disposal. As corrected, the rule provides:

[A] foreign tax satisfies the cost recovery requirement if items deductible under the IRC are capitalized under the foreign tax law and recovered either immediately, on a recurring basis over time, or upon the occurrence of some future event (for example, upon the property becoming worthless or being disposed of), or if the recovery of items capitalized under the IRC occurs more or less rapidly than under the foreign tax law.

As a result, the Technical Corrections clarify that the limitations on amortization of certain intangible assets that are common in many foreign countries will not cause those countries' taxes to fail the cost recovery requirement.

Disregarded sales


Foreign income taxes paid or accrued by a taxpayer are allocated and apportioned to statutory or residual groupings based on the statutory or residual groupings (for example, separate categories or "baskets" for Section 904(d) purposes) to which a taxpayer's foreign gross income is assigned. If a US gross income item arises from the same transaction or other realization event as the foreign gross income item (a corresponding US item), then the foreign gross income item is assigned to statutory or residual groupings based on the groupings to which the corresponding US item would be assigned. Because no corresponding US item can arise from a transaction that is disregarded for US federal income tax purposes, special rules apply to assign foreign gross income arising from such transactions to statutory or residual groupings.

The Final Regulations included rules addressing the allocation and apportionment of foreign income taxes imposed on disregarded payments made between "taxable units." A taxable unit includes, among other things, an entity disregarded as separate from its owner (a disregarded entity), a corporation, an individual and certain other entities. Thus, for example, the Final Regulations' disregarded payment rules allocate and apportion a foreign tax that is imposed when a disregarded entity sells property to a controlled foreign corporation (a CFC) that owns the disregarded entity, or to another disregarded entity owned by the CFC.

Different rules apply to different types of disregarded payments. One rule applies to assign foreign gross income arising from a "reattribution payment," which is the portion of a disregarded payment equal to the sum of all reattribution amounts that are attributed to the recipient of the disregarded payment. A reattribution amount is an amount of gross income that is, by reason of a disregarded payment made by that taxable unit, attributed to another taxable unit. A disregarded payment causes gross income to be attributed to another taxable unit to the extent that a deduction for the payment, if regarded, would be allocated against the payor tested unit's US gross income. A disregarded sale may also be a reattribution payment because disregarded sales reattribute gross income between tested units by reference to the gain that the selling tested unit would have recognized if the sale were regarded.

A payee taxable unit's foreign gross income arising from the disregarded payment is then assigned to categories based on the federal income tax characterization of the reattribution amount. For example, if passive category gross income of a payor taxable unit is reattributed to a payee taxable unit when the payor taxable unit makes a disregarded payment, the payee taxable unit's foreign gross income (and the related foreign income taxes) arising from the disregarded payment is assigned to the same category as the payor taxable unit's US gross income that was reattributed (that is, passive category income).

Notwithstanding the fact that a disregarded sale of property reattributes gross income between tested units, and therefore constitutes a reattribution payment, the Final Regulations included a special rule for disregarded sales that operated as an exception to the reattribution payment rule. Specifically, the foreign law income item arising from a disregarded sale or exchange of property was assigned to statutory or residual groupings by reference to the grouping(s) to which a corresponding US item (that is, built-in gain in the property) would have been assigned if the sale were recognized under federal income tax law.

Technical corrections

Under the Final Regulations, a foreign tax imposed on a disregarded sale could be allocated to a statutory grouping even though a taxpayer did not recognize any gross income in that statutory grouping, leading to lost foreign tax credits and other mismatches. For example, assume that a CFC generated tested income from sales of inventory to third parties. In certain instances, sales of the inventory by the CFC to disregarded entities that distributed such inventory might, if regarded for federal income tax purposes, give rise to foreign base company sales income. Under the Final Regulations, foreign tax imposed on those sales could potentially have been allocated to foreign base company sales income, notwithstanding the fact that the CFC had not, and would not, generate foreign base company sales income.

This result was unnecessary in many instances, in part because a disregarded sale of property reattributes regarded gross income, such that the foreign law gross income (and related taxes) could be allocated and apportioned based on gross income that a taxpayer actually recognized during the tax year. The Technical Corrections address this by providing that foreign gross income attributable to a reattribution payment should be assigned to statutory and residual groupings under the reattribution rules, with only the remaining portion subject to the special rules applicable to disregarded sales.

The rules that apply to the other types of disregarded payments — remittances and contributions — are largely unchanged. The Technical Corrections revise the definitions of the terms "remittance" and "contribution" to exclude a disregarded payment received in exchange for property. Thus, the Technical Corrections prevent a disregarded payment in excess of reattributed income from being treated as a contribution or remittance when such payment is received in connection with a disregarded property sale.

GILTI high-tax exclusion

The elective GILTI high-tax exclusion allows taxpayers to exclude from their GILTI inclusion items of a CFC's gross tested income subject to a high effective rate of foreign tax. The GILTI high-tax exclusion adopts the threshold rate of foreign tax of 18.9% (that is, 90% of the highest domestic corporate tax rate under current law) to determine whether an item is subject to "high tax." Under the Final Regulations, the foreign taxes taken into account for this purpose included "current year taxes" within the meaning of Treas. Reg. Section 1.960-1(b)(4), which generally included any foreign income tax, and was determined without regard to whether the foreign tax credit was disallowed or suspended (for example, by reason of Sections 901(m) or 909).

The Technical Corrections amend the GILTI high-tax exclusion regulations, which now refer to "eligible current year taxes" within the meaning of Treas. Reg. Section 1.960-1(b)(5). Eligible current year taxes do not include a current year tax for which a credit is disallowed or suspended at the CFC level (for example, by reason of Sections 901(m) or 909), but include current year taxes for which a credit is reduced or disallowed at the US shareholder level (for example, by reason of Section 965(g)).


The Technical Corrections include limited revisions to rules coordinating the interaction of the Final Regulations with income tax treaties, and no changes were made to one of the more controversial aspects of the treaty coordination rule. Specifically, the Final Regulations provided that if the relief from the double taxation article of an income tax treaty entitles a citizen or resident of the United States to claim a credit with respect to a foreign tax, then that citizen or resident may claim the credit even though the foreign tax would not otherwise be creditable under the Final Regulations. However, in the Preamble to the Final Regulations, Treasury and the Internal Revenue Service (IRS) noted that CFCs are not treated as US residents under US income tax treaties, and are not entitled to the benefits of those treaties. The implication is that Treasury and the IRS believe that income tax treaties do not provide for a deemed paid credit under Section 960 with respect to foreign taxes imposed on a CFC. That position, which is disputed by many taxpayers, was not reversed in the Technical Corrections.

Applicability dates

The Technical Corrections' applicability dates are those of the underlying Final Regulations that were corrected. As a result, the Technical Corrections to the cost recovery rules apply to foreign income taxes paid or accrued in tax years beginning on or after 28 December 2021. The Technical Corrections to the disregarded sales rules apply to tax years that begin after 31 December 2019, and end on or after 2 November 2020. Finally, the Technical Corrections to the GILTI high-tax exclusion affect tax years beginning on or after 28 December 2021.

What's next?

In public statements, government officials have indicated that the government intends to provide additional guidance relating to the Final Regulations. That guidance may include proposed regulations addressing other troubling aspects of the net gain requirement, such as the attribution requirement. Under the Final Regulations, for example, many countries' withholding taxes imposed on royalties may not be creditable, despite the fact that they have traditionally been creditable and are consistent with widely accepted international tax norms. Proposed regulations are expected to provide additional exceptions to the attribution requirement that would make those taxes creditable, although the scope and effectiveness of those exceptions will remain uncertain until any guidance is issued.

Government officials have also indicated that they continue to consider whether further guidance is warranted under the disregarded payment rules. Those rules allocate and apportion foreign income taxes imposed on remittances by reference to the tax book value of the payor tested unit's assets, which leads to frequent distortions when the assets of the tested unit are assigned to one statutory grouping (for example, cash or bank deposits assigned to the passive category) but the income of the tested unit arises in another category (for example, general category tested income).


Although the Technical Corrections' revisions to the cost recovery requirement broaden the key exception to that rule, it remains unclear whether certain foreign income taxes satisfy the requirement. Additional guidance from the Treasury Department and the IRS in this area would be welcome, including examples of how broadly to interpret "public policy concerns" as well as examples of the cost recovery rule's application to common foreign deduction limitations, such as limitations on deductions for stock-based compensation. In the meantime, taxpayers should carefully consider the impact of the Final Regulations, as amended by the Technical Corrections, on their foreign tax credit position. In particular, taxpayers should further consider the various principles and policies underlying US federal income tax disallowance provisions in light of the broader standard adopted by the Technical Corrections.

Taxpayers with significant disregarded sales of property should consider the impact the Technical Corrections have on their allocation and apportionment of foreign taxes. The Final Regulations' rules on allocating and apportioning foreign income taxes are complex, pose significant compliance challenges and often produce surprising outcomes.

The Technical Corrections to the GILTI high-tax exclusion limit the foreign taxes taken into account for purposes of determining the effective rate of foreign tax on a tested income item. As a result, taxpayers planning to make the GILTI high-tax exclusion election may be required to recognize more tested income than they anticipated.


For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United States), International Tax and Transaction Services
  • Craig Hillier, Boston

  • Colleen O’Neill, Washington, DC

  • Stephen Bates, San Francisco

  • JD Hamilton, New York

  • Enrica Ma, Washington, DC

  • Martin Milner, Washington, DC

  • Joshua Ruland, Washington, DC

  • Ray Stahl, Washington, DC

  • Allen Stenger, Washington, DC

  • Anna Voortman, Chicago

  • Jason Yen, Washington, DC

  • Seth Gray, Washington, DC

  • Jordan Pittman, Washington, DC


For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.


  • Show article references#Hide article references

    1. All “Section” references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.
    2. In addition, the Final Regulations also permitted a foreign gross basis tax to satisfy the net gain requirement if (i) no significant costs and expenses are attributable to the gross receipts included in the foreign tax base, (ii) the foreign tax law does not permit recovery of any costs and expenses attributable to wage income or to investment income that is not derived from a trade or business or (iii) no deduction is permitted for certain other taxes.