On 17 April 2018, IRS published a practice unit on Exhaustion of Administrative Remedies in relation to claims for a foreign tax credit. In order for a foreign tax to be creditable under Section 901, it must be compulsory. A payment is compulsory if it is required under the taxing authority of a foreign government. Treasury Regulation (Treas. Reg.) 1.901-2(a)(2)(i) clarifies that penalties, fines, interest, customs, duties, etc. are not taxes and are not creditable. In addition, foreign taxes paid in excess of what is legally required under foreign law are considered non-compulsory, non-creditable payments. Treas. Reg. 1.901-2(e)(2) states, “an amount is not tax paid to a foreign country to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, abated or forgiven. It is not reasonably certain that an amount will be refunded, credited, rebated, abated or forgiven if the amount is not greater than a reasonable approximation of final tax liability to the foreign country.”
In general, the amount of foreign taxes paid does not exceed a taxpayer’s legal liability (in other words, the payment is compulsory) if the following two factors are met: 1. The amount was determined using a reasonable interpretation and application of the foreign tax law. 2. The taxpayer has exhausted all effective and practical remedies to reduce his or her foreign tax liability over time.
When determining whether taxpayers have exhausted all effective and practical remedies to reduce their foreign tax liability over time, the examiner should give consideration to:
- Whether it is reasonably certain the payment will be returned (refunded, credited, etc.).
- Whether the taxpayer pursued available means to obtain the refund or credit.
- Whether there was a foreign income tax audit, which could be contested on several levels (such as Appeals, competent authority of both contracting countries, court system, etc.).
- Whether the taxpayer’s efforts to contest an issue with the foreign tax authority through available channels (such as Appeals, competent authority, amnesty program, court system, etc.) were adequate and comprehensive. Taxpayers have the burden of proof to show that they exhausted all effective and practical remedies to contest their foreign tax liability.
