IRS provides temporary relief from controversial foreign tax credit regulations

At a glance The main takeaway: Notice 2023-55 provides a reprieve from many elements of certain foreign tax credit regulations. Impact on your business: Taxpayers may choose to apply more favourable prior foreign tax credit regulations, including on a retroactive basis. Next steps: Aprio’s International Tax team can help multinational companies navigate complicated foreign tax credit rules in an effort to relieve a double tax burden on foreign source income.

The full story

On 21 July 2023, the US Treasury Department released Notice 2023-55 (the Notice) which provides temporary relief to taxpayers in determining the creditability of certain foreign taxes by deferring components of Treasury Regulations sections 1.901-2 and 1.903-1, issued 28 December 2021 (FTC Final Regulations).

For tax years beginning on or after 28 December 2021 (i.e. the first tax years for application), and ending on or before 31 December 2023, taxpayers may choose to apply prior regulations (Prior FTC Regulations), which are more favourable, to determine what qualifies as a creditable foreign tax.

The Notice indicates that the Treasury Department and Internal Revenue Service (IRS) are considering proposing amendments to the FTC Final Regulations. Additionally, the Treasury Department and IRS are considering whether, and under what circumstances, to provide additional temporary relief described in the Notice to tax years beyond the relief period.

Background on sections 901 and 903

Section 901 (subject to limitation) allows a taxpayer to claim a credit against its federal income tax liability for foreign income, war profits and excess profits taxes (income taxes). Section 903 provides that income taxes include a tax paid in lieu of a generally imposed foreign income, war profits or excess profits tax (an in-lieu tax and, collectively with income taxes, foreign income taxes).

Foreign Tax Credit (FTC) Regulations

Prior to the issuance of the FTC Final Regulations, Prior FTC Regulations promulgated under section 901 treated a foreign levy as a creditable tax for US federal income tax purposes if:

1. the foreign levy was a tax, and
2. the levy’s character was predominantly that of an income tax in the US sense (the predominant character test).

The predominant character test required an analysis to determine whether the foreign levy was imposed on “net gain” in the “normal circumstances” in which it applies (the net gain test). The net gain test required a foreign levy to meet three requirements: realisation, gross receipts and net income.

The FTC Final Regulations substantially revised the net gain test by revising the three tests, and by adding a new attribution requirement (the attribution test).

A stringent cost recovery requirement in the revised net gain test required foreign tax law to allow recovery of all ‘significant costs and expenses’ attributable to gross receipts in the foreign tax base. Taxpayers were later generally provided with some relief to the cost recovery requirement, but uncertainties and difficulties still remained regarding application of the requirement.

With respect to resident taxpayers, under the attribution test arm’s length principles must be utilised under a country’s transfer pricing rules, which created creditability concerns for taxes in certain foreign jurisdictions (e.g. Brazil). For non-resident taxpayers, the attribution test could be satisfied when one of three tests is met:

1. activities-based attribution test
2. source-based attribution test
3. property-based attribution test.

The introduction of the attribution test was originally intended to limit the creditability of “novel extraterritorial taxes” (such as digital services taxes) which the Treasury believed would undermine the objective of the foreign tax credit regime — namely, the avoidance of double taxation on income properly attributed to a taxpayer’s activities, presence or investment in a foreign jurisdiction (i.e. items of income traditionally taxable by the foreign jurisdiction under generally accepted international tax principles).

However, numerous foreign taxes, previously considered creditable prior to the enactment of the FTC Final Regulations, fail to meet the revised creditability standards as required by the attribution test. For example, in many foreign jurisdictions withholding taxes on royalties are sourced based on location of the payor. However, under US laws royalties are sourced based on place of use of the underlying property that gave rise to the royalties. Because of the differing source rules, generally, such a royalty withholding tax should not be a creditable tax.

Likewise, a similar result occurs with respect to many jurisdictions which apply foreign withholding taxes on cross-border services payments not sourced on the basis of place of performance. Non-resident capital gains taxes (e.g. India) are another foreign income tax affected by the FTC Final Regulations attribution test.

The Notice

The Notice provides temporary relief under Treasury Regulations sections 1.901-2 and 1.903-1 by allowing taxpayers to apply certain aspects of the Prior FTC Regulations instead of the FTC Final Regulations.

First, the Notice allows taxpayers to apply the definition of a foreign income tax and the net gain requirement as defined in Treasury Regulations sections 1.901-2(a) and (b) of the Prior FTC Regulations. This results in a taxpayer only needing to satisfy the prior net gain test (i.e. the realisation, gross receipts and net income tests) instead of the new net gain test as defined in the Final FTC Regulations.

Second, the Notice allows taxpayers to suspend application of the attribution test in the Final FTC Regulations. Since taxpayers are not required to apply the source-based attribution requirements, a foreign country’s sourcing rules do not need to align with US sourcing rules. As a result, many foreign withholding taxes should be creditable that otherwise might not have been under the Final FTC Regulations.

The Notice clarifies that digital services taxes do not satisfy the net income requirement under the Prior FTC Regulations and remain uncreditable as an in-lieu tax. This is consistent with taxpayer expectations and the initial intent to limit the creditability of novel extraterritorial taxes.

Finally, for relief, a taxpayer must adhere to a consistency requirement. For instance, relief must be applied to all foreign taxes of the taxpayer or of any other person, perhaps most notably a controlled foreign corporation held by the taxpayer. Additionally, all members of a consolidated group must apply the temporary relief.

The bottom line

The Notice provides favourable relief to taxpayers with respect to certain foreign taxes that were previously creditable under the Prior FTC Regulations but may be uncreditable under the Final FTC Regulations. Importantly, the deferral of the attribution test allows taxpayers to claim a credit for foreign taxes that may not have been creditable due to lack of an arm’s length transfer pricing system, withholding taxes not based on source rules reasonably similar to those of the USA or non-resident capital gains taxes.

Because the relief period is retroactive to tax years beginning on or after 28 December 2021, taxpayers may need to consider this while finalising their 2022 tax return or consider filing amended tax returns. No relief is granted for foreign taxes paid in tax years ending after 31 December 2023. However, it remains to be seen if this temporary reprieve is effectively a withdrawal.