Crediting (or Not) Foreign Countries’ Digital Services Taxes Under Section 903

This article considers whether digital services taxes are taxes “in lieu of a tax on income.”¹ This has been one of the unanswered questions from the 2017 tax legislation that falls at the intersection of statutory and regulatory interpretation. In addition to the potential impact on the doctrine of Chevron deference, the resolution of this issue has ramifications for the future of the digital economy. Several articles have touched on this specifically and peripherally.²

I. The Basic Structure of the Foreign Tax Credit

Under section 901, a credit may be taken for “income, war profits, and excess profits” taxes. Section 903 provides that taxes paid in the place of those traditional income taxes are also creditable.³ Taxes imposed in addition to traditional income taxes, however, are not “in lieu of” a creditable section 901 tax. For example, in a 1991 revenue ruling discussing a Mexican tax imposed in addition to a “normal” income tax, the government stated that “a foreign levy satisfies the substitution requirement only if it operates in substitution for, not in addition to, an income tax. Taxpayers are subject to both the assets tax and an income tax. Therefore, the assets tax is imposed in addition to the income tax and cannot qualify as an in lieu of tax for purposes of section 903.”⁴ Moreover, the foreign tax credit requires actual payment of taxes, without reimbursement: “[w]hen a taxpayer claims a foreign tax credit for taxes paid and subsequently receives a refund for all or part of those taxes, the taxpayer is required to file an amended return in the United States reducing the foreign tax credit.”⁵ There is, however, a limitation to this credit. “The total amount of the credit taken under section 901(a) shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer’s taxable income from sources without the United States (but not in excess of the taxpayer’s entire taxable income) bears to his entire taxable income for the same taxable year.”⁶

In examining the legislative history for the foreign tax credit, the U.S. Supreme Court indicated that it “clearly demonstrates that the credit was intended to protect a domestic parent from double taxation of its income.”⁷ Since the United States taxes worldwide income (both domestic and international), “a domestic corporation must include foreign source income on its U.S. tax returns even though that income may also have been subject to foreign taxation.”⁸ Nonetheless, domestic taxpayers have been able to claim a dollar-for-dollar credit in the U.S. for income taxes paid to another country since 1918.⁹ This approach is made clear in the legislative history to the 1976 tax reform.¹⁰

II. Digital Services Taxes

A digital services tax purports to tax transactions that occur digitally through an expanded concept of nexus. In early December 2018 in the context of ongoing EU negotiations, France announced that it would unilaterally present a bill to implement a new tax on digital services (the GAFA tax) applicable in France from January 1, 2019.¹¹ The tax was only to apply to companies making in excess of €750 million a year, at a flat 3% rate, with the tax base including “all revenues (i.e., gross revenues) received by the taxpayer (excluding Value Added Tax (VAT)) for taxable services deemed to be made or supplied in France.”¹² The European Commission then discussed a digital services tax (DST) on March 21, 2018 that provided “a single rate of 3% levied on gross income derived from certain digital services for which the French Government deems user participation is essential for creating value; namely, targeted online advertising, which include the sale of user data, and online intermediation services (i.e., platforms), whether they are provided in the context of a relationship between businesses (B2B), businesses and consumers (B2C), or between consumers (C2C).”¹³ On March 6, 2019, the French government submitted a draft bill detailing the French DST proposal to the French Council of Ministers.¹⁴ Since then, DST proposals have arisen and/or been enacted in multiple countries in Europe, Mexico, Brazil, Asia and Africa.¹⁵

A. What Does This Mean for the Concept of “Nexus” in Digital Taxation?

The concept of nexus relates to branches and permanent establishments. A helpful commentary on nexus and its use in dealing with the digital economy is provided by Andres Moreno and Yariv Brauner. They note that “the use of the term became widespread in reliance on an implied nexus between an item of income and a territory to broaden the traditional PE concept contained in Article 5 of both the OECD and the UN Model Tax Conventions,” and suggest that the Article’s physical and personal expansion of the PE concept are also “manifestations of the nexus approach.”¹⁶ In the context of taxation of the digital economy, the nexus approach refers “to the various initiatives to include (at both treaty and domestic law level) an extended concept of Virtual PE or Significant Economic (Digital) Presence and corresponding rules for attributing profits to such newly created PE.”¹⁷ Accordingly, the “existence of a Virtual PE could hypothetically depend on: (1) a revenue factor identified with a (preferably) high threshold of gross revenues generated from remote transactions, calculated on a group basis, combined with either (2) digital factors either in the form of local domain names, local digital platforms, or local payment options, and/or (3) user-based factors, such as monthly active users, online contract conclusion, or data collected.”¹⁸ They note that proposals originally simply reframed nexus/PE to deal with virtual rather than physical presence while “essentially ignor[ing] the complementary profit attribution rules that actually determine the new tax base created by the reform of the rules.”¹⁹ However, there is now a focus on profit allocation.²⁰

The European Union’s 2018 DST proposal was not adopted, though it was revived as part of its financing for a COVID-19 recovery plan.²¹ Several European Union and other countries have adopted similar proposals.²² The DST is not without critics.²³ Indeed, the U.S. Trade Representative initiated section 301 investigations of nine countries’ proposed DST, including the European Commission’s proposal.²⁴

B. Are Foreign Digital Services Taxes Creditable Under Section 903?

It appears the nexus approach underlying the DST is essentially the same nexus approach found in Article 5 of tax treaties for permanent establishment and branch profits. That is, nexus creates a right for the source country to tax the profits of a permanent establishment or branch and that right usually permits a foreign tax credit. It follows that if an item of income is taxed under a nexus approach, then there should be a foreign tax credit attributable under section 903. The major premise is that nexus creates a right for taxation. The minor premise is that if a certain tax is imposed based on that theory of taxation, then other rights related to taxes based on nexus (for credit or exemption) should apply. Accordingly, in the case of the United States, the corollary right is the right to have a section 903 credit for the “in lieu of” tax paid under a DST provision.

Nonetheless, the Treasury and IRS recently proposed regulations on foreign tax credits that would change the rules for creditability of foreign taxes by adding a jurisdictional nexus requirement that would essentially deny a credit for DSTs as failing to satisfy the definition of an ‘in lieu of’ tax.²⁵ This test stems in part from the fact that DSTs and similar digital-economy taxes apply based on destination factors—i.e., location of users, customers, and market access—rather than the physical presence typically used to create permanent establishments. Thus, the Treasury and IRS in these proposed regulations suggest that these new extra-jurisdictional taxes “diverge in significant respects from traditional norms of international taxing jurisdiction.”²⁶ The proposed regulations would provide a credit under sections 901 only if the income satisfies an activities, sourcing, or property-situs nexus. For credit under section 903, jurisdictional nexus would require that the general net-income tax would apply but for the fact that the particular income is excluded from that tax and subject instead to the ‘in lieu’ tax.²⁷ The Preamble does acknowledge, however, that the ongoing OECD/G20 BEPS negotiations may conclude with an agreement on a new international framework for allocating taxing rights that would require changes to the rules in these proposed regulations.²⁸ Thus, the rules may still change. ■

1. § 903; § 1.903-1.
2. See, e.g., Andres Báez Moreno & Yariv Brauner, Taxing the Digital Economy Post BEPS ... Seriously, 58 Colum. J. Transnat’l L. 121, 182 (2019).
3. OECD, Model Tax Convention on Income and on Capital, 376-406 (2017) (recognizing both the exemption and the credit method); David Elkins, A Critical Reassessment of the Role of Neutrality in International Taxation, 40 Nw. J. Int’l L. & Bus. 1, 45 n. 39 (2019).
4. Rev. Rul. 91-45, 1991-2 C.B. 336 (1991).
5. International Tax for the Growing Business, 29 J. Int’l Tax’n 30, 38.
6. § 904(a), (d).
7. United States v. Goodyear Tire and Rubber Co., 493 U.S. 132, 139, 110 S.Ct. 462, 107 L.Ed.2d 449 (1989). See Albemarle Corp. & Subsidiaries v. United States, 118 Fed. Cl. 549, 564–65 (2014), aff’d, 797 F.3d 1011 (Fed. Cir. 2015).
8. Salem Fin., Inc. v. United States, 112 Fed.Cl. 543, 582 (2013), recons. denied, 2014 WL 47541 (Fed.Cl. Jan. 7, 2014).
9. Id.
10. The Senate Report includes a description of foreign tax credit principles.
    
    This foreign tax credit system embodies the principle that the country in which a business activity is conducted (on in which any income is earned) has the first right to tax that income arising from activities in that country, even though the activities are conducted by corporations or individuals resident in other countries. Under this principle, the home country of the individual or corporation has a residual right to tax income arising from these activities, but recognizes the obligation to insure that double taxation does not result. Some countries avoid double taxation by exempting foreign source income from tax altogether. For U.S. taxpayers, however, the foreign tax credit system, providing a dollar-for-dollar credit against U.S. tax liability for income taxes paid to a foreign country, is the mechanism by which double taxation is avoided.
    
    Sen. Rep. No. 94–938, Part I, Tax Reform Act of 1976, P.L. 94–445, § 1031(a).
11. Id.
12. Id. at 22.
13. Id. at 21.
14. Id.
15. See, e.g., Elke Asen, What European OECD Countries are Doing about Digital Services Taxes, Tax Foundation (June 22, 2020) (noting that DSTs have moved forward even while the OECD has been hosting negotiations for reforms to the international tax system).
16. Id. at 168 (noting Articles 5(1) to 5(3) and 5(5) of the Models).
17. Id. at 168–69.
18. Id. at 169.
19. Id. at 172.
20. Id. at 173.
21. See Federal Register Notice (Docket No. USTR-2020-0022) (Notice of Trade Act Investigations).
22. KPMG, Taxation of the Digitalized Economy: Developments Summary (Oct. 27, 2020).
23. See, e.g., 33.04[1] In General, 4 E-Commerce and Internet Law 33.04[1] (2020 update) (“EU digital services taxes also are controversial”).
24. Office of the U.S. Trade Representative, USTR Initiates Section 301 Investigations of Digital Services Taxes (June 2, 2020). These U.S. investigations take place under the 1974 Trade Act.
25. See, e.g., Proposed regulations would revamp creditability rules for foreign income taxes, EY Tax News Update 2020-2645 (Nov. 6, 2020).
26. See Notice of Proposed Rulemaking, REG-101657-20 (Sept. 29, 2020), at 29 (indicating that a foreign tax must “conform to traditional international norms of taxing jurisdiction … in order to qualify as an income tax in the U.S. sense, or as a tax in lieu of an income tax” and to “ensure that the foreign tax credit operates in accordance with its purpose to mitigate double taxation of income that is attributable to a taxpayer’s activities or investment in a foreign country”); Id. at 42 (noting that “several foreign countries have adopted or are considering adopting a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction” and that the Treasury and IRS think it “appropriate to revisit the regulatory definition of a foreign income tax to ensure that to be creditable, foreign taxes in fact have a predominant character of ‘an income tax in the U.S. sense’).
27. Id. at 43 (noting that a tax based on location of customers or other destination-based criterion for allocating profit would not satisfy the jurisdictional nexus requirement); Id. at 44 (if the tax is on income from services, the income must be sourced on place of performance, not location of services recipient).
28. Id. at 45-46 and 45 n.3 (referencing the OECD ‘two-pillar approach’ on taxation of a digital economy).