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Today in Tax: Financial Contract Modification and Foreign Tax Credits



Brief commentary on recent cases, rulings, notices, and related federal tax guidance.

Transition rules allow opportunity to avoid taxable income when modifying financial contracts from IBOR to another metric

Contracts dependent on a discontinued interbank offered rate (“IBOR”) will need to transition to an alternative benchmark. Such a transition, however, may be a realization event for federal tax purposes. To ease the transition to a new qualified rate, the IRS issued final regulations that provide for certain tax-free modifications of affected contracts. Anyone affected by this transition is encouraged to review the regulations and actively plan their transition away from a discontinued IBOR.

In 2017, the U.K. Financial Conduct Authority announced that publication of currency and term variants of the London Interbank Offered Rate (“LIBOR”) would cease in the future. Many financial contracts, including debt instruments and derivative contracts, have historically benchmarked their interest rates on LIBOR or a similar IBOR. Contract modifications can result in a realization event if the resulting contract is materially different from its original terms. The final regulations address the taxability of modifications that replace an IBOR with a qualified rate. The IRS noted that, in the absence of these final regulations, parties affected by the cessation of the publication of LIBOR would suffer tax consequences to the extent that a change to a financial contract results in a tax realization event.

Under the final regulations, a “covered modification” to a contract will not result in a realization event. Generally, covered modifications include replacing a discontinued IBOR, whether it is the operative rate or a fallback rate, with a qualified rate. Covered modifications that replace an operative rate can include a qualified one-time payment to compensate a party for the difference between the discontinued IBOR and the replacement rate. Other technical, administrative, or operational modifications that are necessary to adopt or implement a covered modification (i.e. changes the determination period for interest rates) are allowed and will not result in a realization event.

The final regulations specify that modifications that change the amount or timing of cash flow are excluded from covered modifications. These types of modifications must be tested under the general modification rules to determine whether they cause a realization event. Taxpayers transitioning from a discontinued IBOR to a qualified rate must be aware of what modifications can cause a realization event, as no taxpayer wants to be stuck with a surprise tax bill.

Technology companies may be hard hit by new foreign tax credit limitations

Historically, U.S. taxpayers have been entitled to claim a foreign tax credit (“FTC”) against their U.S. tax liability as a way of reducing double-taxation of foreign-sourced income. The credit is generally permitted for income taxes paid by the U.S. taxpayer to a foreign government. Recent regulations add a new requirement: for foreign taxes to be eligible for the FTC, they must also meet an “attribution” requirement—that is, the tax must be attributable to a taxpayer under foreign law on a similar basis as under U.S. law. Because the U.S. and foreign law differ in many respects, the new regulations will disallow FTCs for foreign taxes that would have previously been creditable, and may result in double taxation for taxpayers subject to digital service taxes and other destination-based taxes throughout the world.

On January 4, 2022, the Department of Treasury and Internal Revenue Service published Treasury Decision 9959 (T.D. 9959) in the Federal Register. The Treasury Decision contains final regulations addressing a number of international tax issues, including new limitations on the foreign tax credit. The final regulations, which are effective for all tax years beginning on and after December 28, 2021, create an immediate issue for U.S. taxpayers conducting business outside the U.S., particularly U.S. taxpayers whose business relates to intangible property such as software or digital services.

Under federal income tax law, U.S. taxpayers are entitled to claim a tax credit against taxes paid to foreign governments if the tax is an income tax or has the predominant character of an income tax. Traditionally, there was no requirement that the tax be “attributable” to the taxpayer under any particular jurisdictional theory other than the requirements in effect in the taxing jurisdiction. Therefore, most foreign income taxes would be creditable.

In recent years, however, several countries have adopted taxes that would apply to U.S. taxpayers solely for selling goods or services to persons located in the foreign country. One common iteration of these taxes is a “digital service tax” or “DST”. The final FTC regulations appear to be taking aim at the imposition of DSTs (and similar tax regimes) by requiring that, to be creditable, a foreign tax must be “attributable” to the U.S. taxpayer on the basis of the U.S. taxpayer’s activities in the foreign country (based generally on U.S. tax principles), the sale of property located in the foreign country, or income having its source in the foreign country (based on U.S. sourcing rules).

The wrinkle here is that not all foreign taxes are imposed on the basis of U.S. tax principles, and not all sources of income are determined by on U.S. sourcing rules. So, in each instance where the U.S. applies tax principles that differ from international norms, there is now the likelihood of double taxation. Further, because of this new attribution requirement, technology companies may be particularly susceptible to U.S. and foreign tax, without the benefit of U.S. FTC, on digital services, software licensing royalties, and other sources of income that may be taxed in a foreign jurisdiction based on the location of the consumer.

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