Are foreign payroll taxes creditable as income taxes for the Foreign Tax Credit?
Foreign payroll taxes must usually meet two tests — the tax test and predominate-character test — to be creditable as income taxes. The tests are applied for each tax independently as per Treas. Reg. § 1.901-2(a)(1)]: “Whether a foreign levy is an income tax is determined independently for each separate foreign levy.”
Here is my analysis of the two tests:
(1) Is it a tax? Treas. Reg. § 1.901-2(a)(2)(i) states, “A foreign levy is a tax if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes. A penalty, fine, interest, or similar obligation is not a tax, nor is a customs duty a tax. … [I]t is not a tax, to the extent a person subject to the levy receives (or will receive), directly or indirectly, a specific economic benefit (…) from the foreign country in exchange for payment pursuant to the levy.” Almost all foreign payroll taxes in my experience are compulsory and are levied by the foreign government or a subdivision thereof.
Regarding the specific economic benefit disqualifier, Treas. Reg. § 1.901-2(a)(2)(ii)(C), titled “Pension, unemployment, and disability fund payments.”, states, “A foreign levy imposed on individuals to finance retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for some substantially similar purpose, is not a requirement of compulsory payment in exchange for a specific economic benefit, as long as the amounts required to be paid by the individuals subject to the levy are not computed on a basis reflecting the respective ages, life expectancies or similar characteristics of such individuals.”
Therefore a FICA- or unemployment-type tax qualifies as a tax if it is not computed on a basis reflecting the respective ages, life expectancies or similar characteristics of such taxpayer. U.S. FICA and unemployment taxes would qualify as taxes under this provision. I ask my clients specific questions about how their foreign payroll taxes are computed in order to determine if they qualify as taxes for FTC purposes. Their payroll taxes usually qualify.
(2) Is the predominant character that of an income tax? Per Treas. Reg. § 1.901-2(a)(3)(i) and (ii) it is if the foreign tax is “likely to reach net gain in the normal circumstances in which it applies” and it is not dependent on the availability of another country’s foreign tax credit. U.S. FICA and unemployment taxes are computed on an individual’s net gain, whether be it salary or net gain from self-employment. Moreover, they are not levied based on the availability of another country’s foreign tax credit. Again I question my clients about their foreign payroll taxes. None in my experience has failed the predominant-character test.
Reference: See also Bittker and Lokken’s, Fundamentals of International Taxation, Boris I. Bittker and Lawrence Lokken (Warren Gorham & Lamont), ¶ 69.4.2:
“. . . ‘a foreign levy imposed on individuals to finance retirement, old age, death, survivor, unemployment, illness, or disability benefits’ is not considered a payment for a specific economic benefit unless the amount of the levy is ‘computed on a basis reflecting the respective ages, life expectancies or similar characteristics of [the] individual’ required to pay it. [Treas. Reg. § 1.901-2(a)(2)(ii)(C)] Foreign taxes analogous to the U. S. social security (FICA) taxes are thus considered taxes, not payments for social security benefits. The same rule applies to a levy imposed for any ‘substantially similar purpose.'”