New U.S. Foreign Tax Credit Rules: Impact on Brazilian Withholding Taxes and Recent Developments

Two developments have paved the way to a favorable window for claiming foreign tax credits on Brazilian withholding income tax (IRRF) for certain import-related transactions: (i) the reform of Brazil’s transfer pricing rules and (ii) new guidance issued by the U.S. Treasury (safe harbor rules). To appreciate their impact, it is key to unpack the recent U.S. tax rule changes and how future modifications may affect their implementation.

Historically, the U.S. worldwide taxation system allowed for foreign tax credits (FTC) on taxes paid abroad by controlled entities. This relief mechanism helps prevent double taxation for multinational groups and reflects the principle of capital export neutrality, whereby the country of residence of the parent entity provides credit for taxes paid to source countries. Under this principle, the source jurisdiction has the “first bite at the apple,” and the U.S. provides a credit to offset its residual tax on global income—a well-accepted concept in international tax.

However, on December 28, 2021, the U.S. Treasury issued final regulations (TD 9959) that introduced a new requirement for FTC eligibility, significantly restricting the scope of foreign taxes that qualify for a credit. These rules, applicable to fiscal years beginning after December 28, 2021, consolidated four requirements for a foreign tax to be creditable:

• Realization
  

• Gross Receipts
  

• Net Income
  

• Attribution (new requirement)
  

The fourth requirement—Attribution—is particularly significant. It mandates that a tax must arise from income that is attributable to the jurisdiction asserting the taxing right, using sourcing rules that are reasonably similar to those applied under U.S. tax law. In effect, this new standard was designed to deny creditability to foreign taxes that do not resemble the U.S. approach to taxing income, especially those imposed on income derived from foreign markets.

This move was partially motivated by growing concerns over unilateral digital services taxes (DSTs) imposed by other countries, which the U.S. government views as infringing on jurisdictional boundaries. Former Treasury Secretary Janet Yellen alluded to these concerns during a congressional testimony on June 16, 2021, particularly in response to questions from Senator Ron Wyden (D-OR).

In simplified terms, under the new rules, foreign income taxes and withholding taxes treated “in lieu of income taxes” must now align with how the U.S. taxes income of nonresidents. That means:

• The tax must be imposed on realized income;

• The starting point for the calculation of income must be gross receipts;

• It must allow for deductions to determine net income;

• And, crucially, it must respect sourcing rules similar to those in U.S. law.

Like most withholding income taxes, the Brazilian IRRF is imposed on the gross amount of royalty payments. The issue is that prior to the introduction of the new transfer pricing rules, Brazil required local payors of cross-border royalties to “cap” their payments and deductions to a fixed percentage of the gross revenues earned with the corresponding piece of intellectual property (generally 5%). For Brazilian payors controlled by U.S. recipients, this would represent a violation of the net income standard, something referred to in a 2023 ruling by the U.S. Tax Court in 3M Co. et al. v. Commissioner as “true net income”.

In addition, Brazilian tax authorities impose IRRF on cross-border payments either (a) having a source of production in the country (i.e., economically used in Brazil) or (b) having been remitted to the recipient by a Brazilian payor. For royalties, this contrasts with IRC Section 861(a)(4), which says that royalty income is only sourced in the U.S. if it is paid for the use of intellectual property within the country.

Under the final regulations, the taxpayer must analyze and demonstrate that a foreign tax meets all four requirements to claim the FTC. One example often cited is a foreign-controlled entity (Entity A in Country X) that holds a license to operate in foreign markets. If Entity A pays royalties to a U.S. entity, and Country X withholds tax on these payments, such withholding would not be creditable unless the royalty income is attributable to activities or assets within Country X.

August 2023 Update: The Single-Country Exception

Recognizing the complexity and restrictive effect of the attribution requirement, the U.S. Treasury released Notice 2023-55 in August 2023, which introduced a “single-country exception”. This provision offers a safe harbor presumption of attribution where:

• The foreign tax is imposed by a country solely on income arising within its own borders;

• The taxpayer can demonstrate that the payment relates to services, licenses, or other activities performed or used exclusively within that country.

For instance, if a Brazilian company pays royalties to a U.S. entity for the use of intellectual property limited to the Brazilian market, and Brazil withholds IRRF on that payment, such tax may now be considered presumptively attributable to Brazil, and therefore creditable under the exception.

This safe harbor creates a pathway for crediting IRRF on payments for services or intellectual property used exclusively in Brazil, mitigating the harshness of the attribution test for common cross-border transactions.

Further relief came with Section 5.04 of Notice 2023-80, issued in late December 2023, which extends the temporary relief introduced in Notice 2023-55. The original relief applied to tax years beginning on or after December 28, 2021, and ending on or before December 31, 2023.

The revised guidance extends this relief indefinitely, or at least until such time as the Treasury issues new regulations or guidance explicitly withdrawing it. This means that, for now, taxpayers may continue to rely on pre-2022 rules for crediting foreign taxes, provided the taxes meet the older standards (e.g., “net gain” test and substitution for income tax).

Practical Implications for the Brazilian Withholding Tax

At first glance, the stricter U.S. rules might seem to disqualify the Brazilian IRRF from FTC eligibility. This conclusion would be premature, however.

Brazilian rules—even though they stem from a patchwork of legislation, some dating back to the 1950s—have evolved in a way that may allow creditability in specific cases. The 2023 single-country exception, in particular, is promising for payments such as royalties, fees for technical services, and similar compensation, provided the income-generating activity is confined to Brazil.

Moreover, Brazil’s ongoing efforts to reform its transfer pricing system to align it with OECD guidelines may further bolster the creditability of Brazilian taxes under U.S. standards, especially regarding the arm’s length principle and the net income calculation requirement. Article 44 of the new transfer pricing law states that royalties (and fees for technical assistance) shall only be treated as nondeductible for local corporate tax purposes if their deduction would result in double nontaxation.

Nonetheless, several features of Brazilian taxation continue to pose challenges:

• Absence or misalignment in the definition of permanent establishment;

• Application of withholding taxes based on remittance and source of production rather than only on source of production;

• Withholding taxes on the gross amount of service payments, which may not permit the deduction of related expenses;

• Overlap between IRRF and other Brazilian taxes that function as turnover or revenue-based levies;

• Cases of voluntary withholding not clearly linked to taxable events under U.S. definitions.

Some of these are longstanding policy choices made by Brazilian authorities (such as the imposition of IRRF on royalties and fees for technical services on a gross basis). Others seem more circumstantial in nature—Brazilian tax treaties have strengthened their permanent establishment clauses in line with Action 7 of the BEPS Action Plan and local courts are slowly building their knowledge base on their practical application (so some harmonization with other countries’ practices should be expected in the future).

Conclusion

The recent announcement of “reciprocal tariffs” on several countries by the U.S. government (including Brazil, currently at 10%) opens a new—and unpredictable—chapter in global trade. Multinational companies operating in both countries must navigate this landscape with close attention to policy shifts and tax planning opportunities.

While the 2021 U.S. FTC regulations marked a turning point in foreign tax creditability, subsequent relief and exceptions—particularly the single-country exception (of August 2023) and temporary relief extension (of December 2023)—signal a more flexible and practical approach, especially for strategic partners like Brazil.

Taxpayers with operations in Brazil should revisit their withholding positions and consider the updated guidance carefully, as a window remains open for crediting IRRF under more favorable interpretations, particularly where source, use, and services are confined to Brazil.