Has the U.S. Treasury Had the Last Word on the ‘End of the Foreign Taxable Year’ Rule?

Posted on Aug. 8, 2022

By Jeffrey L. Gould

To the Editor:

The final foreign tax credit regulations published by the Treasury Department in January (T.D. 9599) have been a source of significant controversy. Much of this is focused on the restrictive new definition of what constitutes a foreign income tax, a matter of concern primarily to U.S. multinationals.1

There are other questionable changes in the new regulations that affect all U.S. taxpayers with a foreign tax liability, including U.S. citizens residing overseas subject to local taxation of worldwide income. One of these is the “end of the foreign taxable year” rule,2 now contained in reg. section 1.905-1(d), that sets out “Rules for accrual method taxpayers.” It now reads in relevant part as follows:

A taxpayer who uses the accrual method of accounting may claim a foreign tax credit only in the taxable year in which the foreign income taxes are considered to accrue for foreign tax credit purposes under the rules of this paragraph (d). Foreign income taxes accrue in the taxable year in which all the events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy. See reg. sections 1.446-1(c)(1)(ii)(A) and 1.461- 4(g)(6)(iii)(B). . . . A foreign income tax liability determined on the basis of a foreign taxable year becomes fixed and determinable at the close of the taxpayer’s foreign taxable year. Therefore, foreign income taxes that are computed based on items of income, deduction, and loss that arise in a foreign taxable year accrue in the United States taxable year with or within which the taxpayer’s foreign taxable year ends. [Emphasis added.]

The new section 905 regulations thus begin by citing the two-pronged requirement for the year-end accrual of liabilities set forth in the section 461 regulations, namely that a foreign tax liability may be accrued when:all the events have occurred that establish the fact of the liability; and the amount of the liability can be determined with reasonable accuracy.

In this context, the all-events test is met if the taxpayer is subject to tax in the foreign jurisdiction — for example, if the taxpayer is a resident. The amount of liability test is met if the liability can be determined with “reasonable accuracy,” which should prove no difficulty if the amount of net income at the close of the U.S. tax year and rate of foreign tax are known. However, the new section 905 regulations go on to imply that a foreign tax imposed based on a foreign taxable year is not “determinable” until the close of that year. This ignores the fact that accrual requires only that a liability be determinable with reasonable accuracy. The regulations conclude with a statement of the

end of the foreign taxable year rule — that foreign income taxes imposed on net income accrue in the U.S. tax year “with or within which” the foreign taxable year ends.

The preamble to the final regulations purports to address the criticism that the end of the foreign taxable year rule ignores the “reasonable accuracy” standard, stating that “an estimate does not meet the standard required by the all-events test to accrue a foreign tax expense.” This is patently untrue — to determine a liability with “reasonable accuracy” clearly contemplates the use of estimates. See, for example, Rev. Rul. 98-39, 1998-2 C.B. 198, which states that a liability can be accrued if it can be “reasonably estimated.” The preamble goes on to say that when the U.S. and foreign taxable year are not coterminous, an estimate of foreign tax liability for the portion of the foreign taxable year up to the U.S. year-end is inherently unreliable because “any number of events” could occur after the U.S. year-end that could affect the foreign liability — for example, a “large loss” could be incurred late in the foreign taxable year. A similar argument could be raised against the accrual of any expense when it is conceivable that post-year-end events could affect the liability, but this would read the “reasonable accuracy” standard out of the regulations.

The “end of the foreign taxable year” rule can have brutal consequences for an individual taxpayer. Consider the case of Mr. X, a U.S. citizen with a calendar-year U.S. taxable year who has previously elected under IRC section 905(a) to claim credit for foreign income taxes in the year in which those taxes “accrued.” Mr. X becomes a U.K. resident on April 6, 2021, and commences to earn a large salary. U.K. income tax will be withheld from his salary at the rate of 45 percent.

According to the IRS, Mr. X cannot accrue and claim any credit for that U.K. tax against U.S. tax on his 2021 U.K. salary because the relevant U.K. taxable year will not have ended until April 5, 2022.3 Mr. X will have an additional U.S. liability on the 2021 U.K. salary of nearly 40 percent and will be paying an aggregate 85 percent income tax on his 2021 U.K. salary.

While the U.K. tax on the 2021 income will be creditable against Mr. X’s U.S. tax for 2022, in the normal case that credit will be needed to offset U.S. tax on income earned by Mr. X during 2022. There will therefore be no unused credit available to carry back to 2021, and the 85 percent liability will become permanent. This is true double taxation, the precise result that the FTC rules and the option to claim the accrual method are intended to prevent.

What makes the Treasury’s insistence on the end of the foreign taxable year rule perverse is that IRC section 905(c) provides that when an accrual of a foreign tax liability proves to be overstated, the taxpayer is obliged to amend the tax return to reduce the credit claimed and pay the additional U.S. tax liability plus interest to the IRS. Thus, in the unlikely event of a large loss incurred late in the foreign taxable year or any other event after the U.S. taxable year-end that reduces accrued foreign tax, the government is fully protected.

In cases in which a right to claim FTCs is conferred by treaty, the new regulations may not be the final word on the time of accrual. The FTC provisions of U.S. treaties typically state that “in accordance with the provisions and subject to the limitations of the law of the United States . . . the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income . . . the income tax paid or accrued to the” other treaty party (emphasis added).

The “law” of the United States is the statutory law and the U.S. Constitution, not federal regulations.4 The two-pronged test for accrual of a liability set out in reg. section 1.461-4(g) represents the accepted interpretation of the meaning of “accrued” as established by the accounting profession and in numerous court decisions.5 It seems possible that a U.S. expatriate adversely affected by the end of the foreign taxable year rule in respect of taxes payable to a U.S. treaty partner could claim accrual based on a reasonable estimate of his foreign tax liability as of the end of the U.S. taxable year, relying on the protection afforded by the applicable treaty.

Jeffrey L. Gould

Youngstein & Gould

London

July 28, 2022

FOOTNOTES

1 See, e.g., letter from the CFOs of 28 U.S. companies to U.S. Treasury Secretary Janet Yellen (June 3,2022).

2 For background concerning the “end of the foreign taxable year” rule, see Gould, “Treasury Must Reexamine the ‘End of the Foreign Taxable Year’ Rule,” Tax Notes Int’l, June 22, 2020, p. 1359.

3 AM 2008-005.

4 The power “to prescribe rules and regulations . . . is not the power to make law — for no such power can be delegated by Congress — but the power to adopt regulations to carry into effect the will of Congress as expressed by the statute.” Manhattan General Equipment Co. v. Commissioner, 56 S. Ct. 397 (1936).

5 See, e.g., United States v. Anderson, 46 S. Ct. 131 (1926).

END FOOTNOTES

United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income . . . the income tax paid or accrued to the” other treaty party (emphasis added).

The “law” of the United States is the statutory law and the U.S. Constitution, not federal regulations.4

The two-pronged test for accrual of a liability set out in reg. section 1.461-4(g) represents the accepted interpretation of the meaning of “accrued” as established by the accounting profession and in numerous court decisions.5 It seems possible that a U.S. expatriate adversely affected by the end of the foreign taxable year rule in respect of taxes payable to a U.S. treaty partner could claim accrual based on a reasonable estimate of his foreign tax liability as of the end of the U.S. taxable year, relying on the protection afforded by the applicable treaty.

Jeffrey L. Gould

Youngstein & Gould

London

July 28, 2022

FOOTNOTES

1 See, e.g., letter from the CFOs of 28 U.S. companies to U.S. Treasury Secretary Janet Yellen (June 3,

2022).

2 For background concerning the “end of the foreign taxable year” rule, see Gould, “Treasury Must

Reexamine the ‘End of the Foreign Taxable Year’ Rule,” Tax Notes Int’l, June 22, 2020, p. 1359.

3 AM 2008-005.

S. Ct. 397 (1936).

5 See, e.g., United States v. Anderson, 46 S. Ct. 131 (1926).

END FOOTNOTES

(C) Tax Analysts 2022. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.liability be determinable with reasonable accuracy. The regulations conclude with a statement of the end of the foreign taxable year rule — that foreign income taxes imposed on net income accrue in the U.S. tax year “with or within which” the foreign taxable year ends.

The preamble to the final regulations purports to address the criticism that the end of the foreign taxable year rule ignores the “reasonable accuracy” standard, stating that “an estimate does not meet the standard required by the all-events test to accrue a foreign tax expense.” This is patently untrue — to determine a liability with “reasonable accuracy” clearly contemplates the use of estimates. See, for example, Rev. Rul. 98-39, 1998-2 C.B. 198, which states that a liability can be accrued if it can be “reasonably estimated.” The preamble goes on to say that when the U.S. and foreign taxable year are not coterminous, an estimate of foreign tax liability for the portion of the foreign taxable year up to the U.S. year-end is inherently unreliable because “any number of events” could occur after the U.S. year-end that could affect the foreign liability — for example, a “large loss” could be incurred late in the foreign taxable year. A similar argument could be raised against the accrual of any expense when it is conceivable that post-year-end events could affect the liability, but this would read the “reasonable accuracy” standard out of the regulations.

The “end of the foreign taxable year” rule can have brutal consequences for an individual taxpayer.

Consider the case of Mr. X, a U.S. citizen with a calendar-year U.S. taxable year who has previously elected under IRC section 905(a) to claim credit for foreign income taxes in the year in which those taxes “accrued.” Mr. X becomes a U.K. resident on April 6, 2021, and commences to earn a large salary. U.K. income tax will be withheld from his salary at the rate of 45 percent.

While the U.K. tax on the 2021 income will be creditable against Mr. X’s U.S. tax for 2022, in the normal case that credit will be needed to offset U.S. tax on income earned by Mr. X during 2022.

There will therefore be no unused credit available to carry back to 2021, and the 85 percent liability will become permanent. This is true double taxation, the precise result that the FTC rules and the option to claim the accrual method are intended to prevent.

What makes the Treasury’s insistence on the end of the foreign taxable year rule perverse is that IRC section 905(c) provides that when an accrual of a foreign tax liability proves to be overstated, the taxpayer is obliged to amend the tax return to reduce the credit claimed and pay the additional U.S.

tax liability plus interest to the IRS. Thus, in the unlikely event of a large loss incurred late in the foreign taxable year or any other event after the U.S. taxable year-end that reduces accrued foreign tax, the government is fully protected.

Document generated for Jeffrey Gould