Why This Matters
Where a treaty permits a foreign jurisdiction to tax income that U.S. law treats as U.S. source, a U.S. taxpayer may be limited in their ability to claim a foreign tax credit unless the income is treated as foreign source for U.S. foreign tax credit limitation purposes. Thus, the ability to rely on a treaty re-sourcing provision to treat such income as foreign source may be critical to avoiding double taxation.
Background - Treaty Sourcing Rules
U.S. tax treaties typically address how income is sourced for purposes of calculating a U.S. resident's foreign tax credit limitation. Many modern treaties include explicit re-sourcing provisions. However, some treaties limit the impact of the re-sourcing provision through inclusion of "subject-to" language, as described above.
In such treaties, the precise meaning of this "subject-to" formulation has not always been clear. Commentators have argued that this formulation should not be interpreted to allow all general source rules under the Code to override treaty-based determinations of source.
Until recently, this lack of clarity has created substantial uncertainty regarding interpretation of the re-sourcing rules under sections 865(h) and 904(h)(10), described below.
Relevant Code Provisions
- Section 865 - Generally, gain from the sale of personal property by a U.S. resident is U.S. source under section 865(a). However, 865(h) provides for an election to treat certain gain from the sale of foreign stock or intangible assets as foreign source where an applicable treaty (applied without regard to section 865(a)) allows for re-sourcing.
- Section 904 - Section 904 generally provides rules for the purpose of determining the amount and character of foreign source income for which a foreign tax credit can be claimed. Section 904(h) overrides the general sourcing rules for certain subpart F income, tested income, income from qualified electing funds, interest, and dividends. This was meant to prevent U.S. taxpayers from artificially increasing their foreign source income amount by routing U.S. source income through certain U.S.-owned foreign corporations. Section 904(h)(10), an exception to the exception under 904(h), governs the extent to which a taxpayer may apply treaty-based sourcing rules (applied without regard to the general rule of 904(h)) to determine a taxpayer's foreign tax credit limitation amount with respect to such items of income.
What the PLRs Address and What They Mean for Taxpayers
In both rulings, the IRS permitted section 865(h) elections without addressing the question of whether the treaty's deferral to domestic law limited the taxpayer's ability to rely on Code-based re-sourcing provisions that give effect to treaty-based sourcing. The rulings hold that section 865(h) may be applied to achieve treaty-consistent sourcing outcomes even in the case of a treaty that contains a "subject-to" clause. The same rationale of the rulings should apply to section 904(h)(10). The favorable 904(h)(10) implications of the rulings were expressly called out by Peter H. Blessing, Associate Chief Counsel - International, at a recent Practising Law Institute public panel in Washington, DC.
Taxpayers operating multinational enterprises in jurisdictions with treaties that have the "subject- to" clause should not assume those provisions foreclose re-sourcing opportunities. These PLRs suggest that the IRS does not view treaty provisions that defer to domestic-law sourcing as limiting a taxpayer's ability to rely on sections 865(h) and 904(h)(10).
The Relevant Treaties
Taxpayers with cross-border transactions involving countries with treaties that have the "subject- to" formulation (listed below) should consider whether these Code provisions offer planning opportunities to mitigate double taxation:
- Austria
- Estonia
- India
- Ireland
- Indonesia
- Latvia
- Lithuania
- Luxembourg
- Sweden
- Thailand
- Türkiye
How Venable Can Help
Contact the authors if you have questions about cross-border transactions that could implicate tax treaties. Venable's tax team can evaluate the implications of recent developments such as this one, assess potential planning opportunities, and implement planning solutions for your multinational business.