Can Foreign Withholding Tax on Patent Infringement Damages Qualify for a Foreign Tax Credit?

There has been an increase in cross-border patent litigation that has been driven by the globalization of innovation. These types of cases are often resolved through settlement agreements. For a U.S. corporation or individual receiving payment of a patent infringement damage award from foreign entity, the U.S. patent holder will have distinct tax considerations. First, the U.S. patent holder must consider if there are foreign tax consequences associated with recovery of damages associated with the patent infringement damage award. Second, the U.S. patent holder must not only consider the U.S. tax consequences of the recovery, the U.S. patent holder must also determine if the payment of foreign taxes are creditable against any U.S. tax.

To illustrate, let’s assume that Techco, a Wyoming company entered into a patent infringement settlement agreement with Cellphone Maker (A foreign corporation located in Country A) involving U.S. patents for $100 million, which was subject to 30% Country A withholding tax ($30 million withholding tax). This article will discuss if the foreign $30 million withholding tax is creditable against Techco’s U.S. tax.

Overview of Foreign Tax Credit Rules

U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign taxes paid or accrued. The main purpose of the foreign tax credit is to mitigate the double taxation of foreign source income that might occur if such income is taxed by both the United States and a foreign country. However, as will be discussed below, the foreign tax credit rules are complicated and there are a number of significant limitations on a U.S. taxpayer’s ability to claim a foreign tax credit.

Credit Versus Deduction

Taxpayers have the option of deducting foreign income taxes in lieu of taking a credit. Generally, a credit is more advantageous than a deduction because it reduces a person’s tax dollar for dollar as opposed to a reduction in taxable income. For example, if a domestic corporation is subject to U.S. tax at a 21% rate, deducting $1 of foreign income taxes saves only $0.21 in taxes, compared to $1 in tax savings from a credit.

The choice between a deduction and a credit applies to all foreign income taxes paid or accrued during the year. In other words, a taxpayer cannot claim a credit for a portion of the foreign income taxes incurred in a taxable year and deduction for the remaining foreign income taxes. However, taxpayers can change their election from year to year. In addition, taxpayers can change their election any time before the expiration of the statute of limitations, which is 10 years in the case of a refund claim based on the foreign tax credit.

It would be more beneficial for Techco to attempt to classify Country A’s withholding taxes as a foreign tax credit compared to claiming a deduction for the withholding taxes. With that said, Country A’s withholding taxes do not qualify for foreign tax credit treatment for U.S. tax purposes, Techco may potentially claim a deduction for the amount of Country A’s withholding taxes paid. We will discuss characterizing Country A’s withholding taxes as a deduction in more detail later in this article.

Who Can Claim a Foreign Credit

Taxpayers entitled to claim a foreign tax credit primarily include U.S. citizens, resident aliens, and domestic corporations.  A U.S. citizen, resident alien or domestic corporation that is a partner in a partnership may claim a credit for a proportionate share of the creditable foreign taxes incurred by the partnership. The rules applicable to partners in a partnership also apply to shareholders in an S corporation.

Creditable Foreign Income Taxes

Under Section 901 of the Internal Revenue Code, U.S. persons and corporations are entitled to a foreign tax credit for “the amount of any income, war profits, and excess profits taxes paid or accrued during the tax year to any foreign country or any possession of the United States.” Section 903 extends the credit to foreign taxes imposed “in-lieu-of” an income tax. In order to claim a foreign tax credit for foreign taxes paid, the following conditions discussed below must be satisfied:

1. A foreign tax is eligible for a credit if it was a compulsory payment pursuant to the authority of a foreign government to levy taxes. Only compulsory payments are considered payments of tax. A payment is not compulsory to the extent that the amount paid exceeds the amount of liability under foreign law for tax. The regulations provide that “[a]n amount paid does not exceed the amount of such liability if the amount paid is determined by the taxpayer in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer’s reasonably expected liability under foreign law for tax.” An interpretation or application of foreign law is not considered reasonable if the taxpayer has actual notice or constructive notice, such as a published court decision, that the interpretation or application is likely to be erroneous.

A taxpayer must also exhaust all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer’s liability for foreign tax (including liability pursuant to a foreign tax audit adjustment). A remedy is “effective and practical” only if the cost (including the risk of offsetting or additional tax liability) is reasonable in light of the amount at issue and the likelihood of success.

For example, in Procter & Gamble Co, et all. v. United States, No 1:08-cv-00608-TSB, a federal district court held that a taxpayer must initiate competent authority proceedings even where double taxation arises because of conflicting claims by two foreign countries, as opposed to between the United States and a foreign country. Procter & Gamble claimed a credit for Japanese taxes paid in several tax years. In a later year, the Korean tax authorities determined that the income with respect to which the Japanese taxes had been paid was also subject to tax in Korea. The IRS disallowed Procter & Gamble’s claim for a foreign tax credit for the Korean taxes. The court determined that although Procter & Gamble was required to pay Korean tax, and was reasonably advised as to the legality and accuracy of the Korean claim by its Korean counsel, Protector & Gamble failed to exhaust all effective and practical remedies including invocation of competent authority procedures available under applicable tax treaties to reduce the tax liability owed to Japan.

The 30% Country A withholding taxes assessed on settlement agreement with Cellphone Maker is a compulsory payment pursuant to the authority of a foreign government. Even though Country A’s withholding tax is a creditable tax for U.S. tax purposes, Techco must exhaust all effective and practical remedies under Country A’s law in order for the withholding tax to be credible. Thus, if Country A has a process to reduce the 30% withholding tax, Techco must exhaust its remedies with Country A’s tax authorities before claiming the foreign tax credit. If the United States has a tax treaty with Country A that provides for a more favorable withholding rate than 30%, Techco must file tax returns with Country A’s tax authorities and take a treaty position requesting a reduced withholding rate. Techco must exhaust all practical remedies in Country A to claim the reduced treaty withholding rate, including making a competent authority request. This all must be done before claiming a foreign tax credit for U.S. tax purposes.

2. For many years the centerpiece of the law on whether a foreign tax qualifies as a creditable tax under Section 901 of the Internal Revenue Code is the requirement in Treasury Regulation Section 1.901-2(a)(1)(ii) that “[t]he predominant character of [the] tax is that of an income tax in the U.S. sense.” Treasury Regulation Section 1.901-2(a)(3)(i), in turn, provides that a foreign tax will meet this requirement only if the “tax is likely to reach net gain [in the] normal circumstances in which it applies.”

A two part test had to be satisfied in order to satisfy the “predominant character test.” The first requirement is that the foreign tax must be “likely to reach net gain in the normal circumstances in which it applies” Three conditions had to be satisfied for a tax to meet this “net gain” criterion. First, the tax had to meet a “realization requirement.” In general, this requirement was satisfied where the tax was imposed upon or subsequent to the occurrence of events that would result in the realization under the U.S. tax law. Second, the foreign tax must have been imposed on the basis of gross receipts computed under a method that was likely to produce an amount that is not greater than its fair market value. Third, the tax must satisfy a “net income requirement” in which the base of the tax must be computed by reducing gross receipts to permit recovery of significant costs and expenses. The second requirement under this predominant character test is that the foreign tax provided that a foreign tax had to be an income tax in the U.S. sense only to the extent that liability for the tax could not have been dependent on the availability of a credit for the tax in another country.

A standard feature of Country A’s withholding taxation is the imposition of withholding taxes on the gross amounts of payments such as payments for royalties (which would be characterized as fixed or determinable annual or periodical income under Sections 871(a)(1)(A) and 881(a)(1) of the Internal Revenue Code paid by domestic persons to foreign persons. Under the regulations of the Internal Revenue Code, foreign gross basis withholding taxes on income similar to taxes imposed by the United States under Sections 871(a)(1)(A) and 881(a)(1), are generally creditable as “in lieu of” taxes under Section 903 of the Internal Revenue Code. Since the Country A’s withholding tax can be considered “in lieu of” taxes under Section 903, the withholding taxes on the settlement agreement is potentially creditable.

It should be noted that even if the withholding tax satisfies the predominant character test discussed above, the tax will still be denied income tax status if it is a soak-up tax.  According to the regulations, a foreign levy is a creditable income tax or tax “in lieu of” an income tax only to the extent that it is not dependent on the availability of a foreign tax credit in the taxpayer’s home country. A foreign tax that is conditioned on the ability of the taxpayer to claim a foreign tax credit at home is usually called a “soak-up” tax and is not creditable.

New Jurisdictional Nexus Requirement

In 2020, the IRS and Treasury issued proposed regulations that added a “Jurisdictional Nexus Requirement” to the aforementioned requirements in order to claim a credit for a foreign tax. Under this “Jurisdictional Nexus Requirement,” a foreign tax will be creditable for U.S. tax purposes only if the the foreign country imposing the tax has sufficient nexus to a U.S. taxpayer’s business’s activities, investment of capital or other assets that gave rise to the foreign income and foreign tax. This rule prevents taxpayers from claiming a credit for foreign taxes that do not conform to traditional internationally accepted taxing norms and tax homes that lack a strong connection to that country. These rules were enacted in response to the rise for novel extraterritorial taxes such as for digital services. Country A’s withholding tax has a proper jurisdictional nexus for foreign tax credit because the withholding tax is being assessed on a payment from a company that is located in that jurisdiction.

Sourcing Rules Applicable to Claim a Foreign Tax Credit

The United States taxes U.S. persons on all their income, from whatever source derived. Therefore, the source of income generally has no effect on the computation of a U.S. person’s taxable income. Sourcing can have a significant effect, however, on the computation of a U.S. person’s foreign tax credit. The U.S. source rules in general derive from an attempt to identify the geographic locus of the economic activity or financial arrangement that generated the income. The question is always whether income and related deductions and credits derive from inside or outside the United States. According to Internal Revenue Code Section 7701(a)(0) the “‘United States’ when used in a geographical sense includes only the States and the District of Columbia.” As indicated above, the source of income is essential to the calculation of the foreign tax credit. Because the foreign tax credit is intended to limit or mitigate double taxation of foreign-source income, the credit is generally accorded only with respect to foreign taxes on foreign source income.

Techco entered into a patent license and settlement agreement with Cellphone Maker (a resident of Country A) for a matter involving U.S. patents. Income from patents will be treated as royalty income for purposes of the sourcing rules. The source of royalty income for intangible properties, such as patents, copyrights, trade secrets, trademarks, and goodwill, depends on where the rights are used, which is generally the country in which the intangible property derives its legal protection. In this case, the patent litigation with Cellphone Maker has exclusively focused on U.S. patents and not Country A’s patents. The application for determining the source of royalty income in practice can be a very challenging task. Arrangements for the exploitation of intellectual property interests involving patents often involve rights protected by the laws of the United States and perhaps several other countries, thereby requiring an allocation between U.S. -and foreign-source income. In this case, Techco’s ability to claim a foreign tax credit associated with the Country A’s withholding tax on the settlement should be based on its ratio of net taxable income from foreign sources to net taxable income from all sources. Under the allocation rules, Techco should apportion to a reasonably close extent, a factual relationship between the foreign tax credit and its gross income in connection with the settlement. Examples of apportionment bases include gross income, gross receipts or sales, costs sold, profit contributions, expenses incurred, assets used, salaries paid, space utilized, and time spent. The effect of the resulting apportionment on the tax liability and the related record-keeping burden are both considered when determining whether or not the apportionment is sufficiently precise. See Temp Reg. Section 1.861-8T(c)(1).

The Importance of the Sourcing Rules for Purposes of Claiming a Foreign Tax Credit

The source-based attribution requirement is satisfied if gross income or gross receipts that are included in the foreign tax base are: 1) limited to gross income arising from sources within the foreign country; and 2) determined based on sourcing rules that are reasonably similar to those that apply to Section 864. Gross income or receipts may be included in the foreign tax base on source based income as determined based on the sourcing rules found in the Internal Revenue Code. For example, income from services must be sourced based on where the services are performed. While royalty income must be sourced based on the place of use of, or the right to use, the intangible property. Foreign tax imposed on residents of the foreign country permits the worldwide gross receipts of a resident to be included in the foreign tax base, but any profit allocation must be at arm’s length as per the U.S. transfer pricing rules. Foreign tax law governing the sourcing of taxes need not duplicate U.S. tax law. However, foreign tax law sourcing law should have the same general theory as U.S. tax law.

Unfortunately, the relationship between deductions and U.S. and foreign operations often is ambiguous. For example, in concept, a U.S. exporter should apportion its marketing expenses between the U.S. and foreign sources based upon the relative amounts of marketing resources expensed to generate U.S., as opposed to foreign, sales. However, often it is unclear which, if any, of conventional apportionment bases, such as unit sales, gross sales, or gross margin, accurately reflects this relation. Moreover, if the mix of products sold in the United States differs from the mix of products sold abroad, the use of different apportionment bases will lead to different results. Illustrations 1 and 2 discussed below provide examples regarding the apportionment rules.

Illustration 1.

USAco is a domestic corporation that sells its products both in the United States and abroad. During the current year, USAco had $10 million of sales and a gross profit of $5 million, and incurred $1 million of selling, general, and administrative (“SG&A”) expenses. USAco’s $10 million of sales included $6 million of foreign sales and $4 million of domestic sales. On the other hand, because USAco’s domestic sales generally involved higher margin products than its foreign sales, USAco’s gross profit of $5 million was split 50-50 between U.S. and foreign sales. Thus, if USAco uses gross profit as an apportionment base, it would apportion $500,000 of SG&A expenses to foreign-source income [50% x $1 million of SG&A expenses], as opposed to $600,000 if gross sales is used as an apportionment base [($6 million of foreign sales divided by $10 million of total sales) x $1 million of SG&A expenses]. See Treas. Reg. Section 1.861-8(g), Example 19.

Illustration 2.

The facts are the same as the last example, except now assume that USAco’s SG&A expenses of $1 million consist of the president’s salary of $250,000, the sales manager’s salary of $100,000 and other SG&A expenses of $650,000. Also assume that USAco’s president and sales manager maintain time records which indicate that the president devoted 30% of her time to foreign operations and 70% to domestic operations. USAco should now apportion the salaries of the president and sales manager on the basis of time spent and apportion the other SG&A expenses on the basis of gross profit. Therefore, USAco apportions to foreign-source income $75,000 of the president’s salary [30% x $250,000], $40,000 of the sales manager’s salary [40% x $100,000], and $325,000 of the remaining SG&A expenses [50% x $650,000], for a total of $440,000 of SG&A expenses apportioned ro foreign-source income. See Treas. Reg. Section 1.861-8(g), Example 20.

For the purposes of the sourcing rules, research and development expenditures are apportioned between U.S. and foreign-source income using the sales apportionment method or an optional gross income apportionment method. See Treas. Reg. Section 1.861-7 and IRC Section 864(g). Under the sales method, one-half of the research and development costs is allocated to the place at which the research and development activities were performed and the remaining half of the costs is prorated between U.S. and foreign sources according to sales. Under the gross income method, one-fourth of the costs is allocated exclusively to the pace at which the research and development activities were performed and the remainder is apportioned according to gross income.

Legal and accounting expenses incurred with respect to a specific property or activity (for example, to obtain a patent) are allocated to the gross income produced by that property or activity (for example, royalties from the patent). On the other hand, the cost of general legal and accounting functions is allocated to all gross income and apportioned on the basis of gross income. See Treas. Reg. Section 1.861-8(e)(5).

It may be possible for Techco to claim a foreign tax credit in connection with at least a portion of the Country A’s withholding taxes. However, it must source the deduction associated with the foreign withholding tax. This would be done by Techco allocating its income and expenses between domestic and foreign sources.

Claiming a Deduction for the Foreign Withholding Tax

As discussed above, in the alternative to claiming a foreign tax credit, Techco can claim a deduction for the withholding tax. Internal Revenue Code Section 162 provides the general rule for deducting “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” This provides a broader framework for business deductions, including certain taxes. A deduction for foreign taxes is specifically discussed in Section 164 of the Internal Revenue Code. Section 164(f)(h)(3) specifically permits a deduction of foreign taxes imposed by the authority of a foreign country as long as the tax was incurrent in a trade or business. Country A’s withholding tax was imposed against Techco’s on settlement proceeds received from a patent suit. Under these circumstances, Techco can likely claim a deduction for the withholding taxes paid.

Conclusion

The foregoing is intended to provide the reader with a basic understanding of a foreign withholding tax and if a foreign withholding tax is creditable against U.S. tax. It should be evident from this article that this is a complex area of tax law and that this area of tax law is subject to constantly new developments and changes. U.S. businesses and individuals that have or will receive payments from a foreign business from a patent infringement suit should consult with an international tax attorney.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has substantial experience advising clients that have received payments pursuant to a settlement or judgment received patent licensing and infringement cases.

Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.