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IRS issues temporary foreign tax credit relief
July 2023
In brief
Treasury and the IRS on July 21 issued Notice 2023-55 (the ‘Notice’), which announces temporary relief for taxpayers in determining whether a foreign tax may be creditable under Sections 901 or 903 in a tax year (‘relief year’) beginning on or after December 28, 2021, and ending on or before December 31, 2023 (the ‘relief period’).
During the relief period, taxpayers that satisfy certain consistency requirements may determine the creditability of foreign taxes under standards set forth in former regulations under Section 901 (for a net income tax) and revised regulations under Section 903 (for an ‘in lieu of’ tax).
Treasury and the IRS continue to analyze issues relating to final regulations (T.D. 9959) published on January 4, 2022 under Sections 901 and 903 (the ‘2022 final regulations’), and are considering proposing amendments to those regulations. Treasury and the IRS also are considering whether, and under what conditions, to provide additional temporary relief beyond the relief period.
The takeaway: These changes permit taxpayers to determine the creditability of their foreign income taxes and ‘in lieu of’ taxes without satisfying the attribution requirement and the more onerous cost recovery requirement promulgated in the 2022 final regulations. This relief is expected to favorably affect the creditability of foreign taxes, such as certain Brazilian corporate income taxes, various services and royalty withholding taxes, and nonresident capital gain taxes. The relief generally is available for calendar tax years 2022 and 2023 and for fiscal tax years ending in 2023. Taxpayers that already have filed a 2022 tax return should consider filing an amended return.
Actions to consider: Taxpayers should re-evaluate each of the foreign taxes that previously had been disallowed as a foreign tax credit (‘FTC’) as a result of the 2022 final regulations to determine whether such disallowed taxes may be creditable under Sections 901 or 903 during the relief period. If taxpayers seek relief under the Notice, any resulting change in position, as documented on a filed income tax return, may be treated as a foreign tax redetermination under Section 905(c), which may trigger reporting requirements under Reg. sec. 1.905-4. Such redetermination may affect tax return and financial accounting positions taken with respect to the FTC, as well as other provisions of the Code and regulations that refer to creditable foreign income taxes, such as the high tax exceptions under the global intangible low-taxed income (GILTI) and subpart F rules of Reg. sec. 1.951A-2(c)(7) and Section 954(b)(4), respectively.
In detail
Background
The 2022 final regulations fundamentally changed the framework for determining which foreign taxes were considered net income taxes or taxes ‘in lieu of’ net income taxes for which a credit generally is available under Section 901. With respect to net income taxes, those regulations require taxpayers to, among other things, (1) conduct a more thorough analysis of foreign law deduction disallowances under the ‘cost recovery’ requirement, and (2) determine that the foreign tax being considered meets an ‘attribution’ requirement that, depending on whether the foreign tax was imposed on residents or nonresidents of the foreign country, requires that the foreign tax law contain certain provisions, and be applied, in a manner viewed as consistent with the US federal income tax regime. With respect to ‘in lieu of’ taxes, the 2022 final regulations added, among other things, an attribution requirement that requires that the foreign tax law be imposed in a manner reasonably consistent with how the US would source income and determine its taxing jurisdiction. See prior PwC Insight regarding the 2022 final regulations.
Following the 2022 final regulations, Treasury and the IRS received numerous comments and questions regarding the application of the 2022 final regulations and requests to modify those regulations. In response, Treasury and the IRS issued a correction to the 2022 final regulations in July 2022 that addressed some of the issues raised by the new rules under the cost recovery requirement, and then released proposed FTC regulations (the ‘2022 proposed regulations’) on November 18, 2022, which included proposed rules relating to the cost recovery requirement and the new single-country exception to the source-based attribution requirement for covered withholding taxes. Notice 2023-31, issued in March 2023, extended the period of time during which taxpayers could update agreements to retroactively qualify for the ‘single-country license’ exception in proposed Reg. sec. 1.903-1(c)(2)(iii)(B).
With the issuance of Notice 2023-55, Treasury and the IRS indicated that they are continuing to consider the issues raised by the 2022 final regulations and proposed amendments to those regulations, and have decided to provide taxpayers with temporary relief from applying certain aspects of the 2022 final regulations.
Notice 2023-55
Creditable taxes
Notice 2023-55 provides temporary relief for taxpayers in determining whether a foreign tax is a foreign income tax that may be creditable under Sections 901 or 903.
Under the Notice, taxpayers that satisfy certain consistency requirements may determine the creditability of foreign taxes under slightly modified former regulations under Section 901 and revised regulations under Section 903 (together, the ‘Modified Regulations’):
- A foreign net income tax may be determined under Reg. sec. 1.901-2(a) and (b), as it existed on April 1, 2021, prior to the promulgation of the 2022 final regulations, with modifications intended to prevent gross basis taxes and digital services taxes from qualifying as foreign net income taxes, and
- An ‘in lieu of’ tax may be determined under Reg. sec. 1.903-1(c) without Reg. sec. 1.903-1(c)(1)(iv) and (2)(iii), which requires ‘in lieu of’ taxes to satisfy an attribution requirement.
Before the 2022 final regulations, a foreign levy qualified as a net income tax if it had the predominant character of an income tax, as determined under a three-part net gain requirement: realization, gross receipts, and net income. The net income requirement is the antecedent to the 2022 final regulations’ cost recovery requirement, but it was significantly more flexible than the cost recovery requirement. It referred generally to significant costs and expenses instead of listing expenses that were per se significant (e.g., capital expenditures, interest, rents, royalties, and service payments). Furthermore, in testing foreign taxes under the predominant character standard, the former regulation did not seek conformity between particular foreign law cost recovery rules and the rules or principles that govern deductibility under the Code.
Impact of Notice
As stated in Notice 2023-55, taxpayers may apply the former regulations’ net income standard as modified by disqualifying all gross basis taxes other than taxes the base of which consists of only wage income or investment income that is not derived from a trade or business. The Notice states that a digital services tax imposed on a base of gross receipts or gross income (DST) does not satisfy the modified net income requirement because, while the base of such a tax is gross receipts or gross income, such amounts do not consist solely of wage income or investment income that is not derived from a trade or business.
The Notice permits taxpayers to apply the 2022 final regulations’ substitution requirement to determine creditability of ‘in lieu of’ taxes without the provisions that require conformity with the attribution requirement. The Notice states that a DST that applies to any income that also could be subject to the foreign country’s net income tax remains non creditable, because the substitution requirement requires that the tested ‘in lieu of’ tax not duplicate any amount included in the base of the taxing jurisdiction’s net income tax.
The Notice also clarifies that when applying temporary relief, the examples and cross-references in the former regulations should be modified appropriately (e.g., references to "foreign income tax" in the existing regulations include foreign taxes that satisfy the requirements under the modified former Reg. sec. 1.901-2(a) and (b), and examples 1-3 of Reg. sec. 1.901-2(b)(4)(iv) are deleted).
Observation: The 2022 final regulations imposed strict conditions like the attribution requirement and the more stringent cost recovery requirement, and did not apply a predominant character standard. However, these restrictions have been relaxed as a result of this Notice for the relief period, potentially resulting in a more favorable treatment of problematic foreign taxes under the 2022 final regulations, including certain Brazilian corporate income taxes, various services and royalty withholding taxes, and nonresident capital gain taxes, as creditable foreign income taxes. This relief applies to both calendar tax years 2022 and 2023, as well as fiscal tax years ending in 2023. Taxpayers that already have filed their 2022 tax return should consider submitting an amended return seeking to take advantage of the relief.
Furthemore, although the Notice explains why certain DSTs may not satisfy the Modified Regulations, further analysis is necessary to determine whether certain DSTs either permit the recovery of costs or expenses or are imposed on a base that is excluded from the base of any net income tax levied by the taxing jurisdiction.
Relief requirements
The Notice does not require taxpayers to specifically indicate in a statement or form that they are applying the relief provisions set forth in the Notice. However, to qualify for the Notice’s relief with respect to a relief year, taxpayers and members of their consolidated groups must apply the Modified Regulations to (1) all foreign taxes that the taxpayer paid or accrued in such relief year and (2) all foreign taxes paid by other persons (e.g., CFCs) in tax years starting on or after December 28, 2021, and ending with or within such taxpayer's relief year, for which the taxpayer would be eligible to claim a credit under Section 901 (determined without regard to the limitations described in Reg. sec. 1.901-1(b)), if the taxpayer applied the temporary relief to such foreign taxes. The taxpayer cannot apply the temporary relief to claim a credit under Section 901 for any foreign tax amount for which a deduction is allowed in the relief year or any other taxable year.
Potential future developments
Treasury and the IRS continue to analyze issues relating to the 2022 final regulations, and are considering proposing amendments to those regulations. Treasury and the IRS also are considering whether, and under what conditions, to provide additional temporary relief beyond the relief period.
Observation: Although Treasury and the IRS are considering additional relief, it is not clear whether the Notice signals a reversal or rethinking of the positions contained in the 2022 final regulations, or mere temporary relief until the regulations’ technical issues can be refined further. The Notice only provides one year of relief to taxpayers with a year-end other than December 31, such as those whose fiscal year ends in June or September, because it only applies to tax years ending on or before December 31, 2023. As a result, taxpayers should evaluate what actions may be necessary to support the future creditability of foreign taxes that may not have been creditable under the 2022 final regulations.
Observation: The relief provided in Notice 2023-55 is limited in duration and scope, as it only effectively allows taxpayers to turn off the application of Reg. sec. 1.901-2(a) and (b) as applied in determining whether a tax is a net income tax or ‘in lieu of’ tax. Thus, other provisions of the 2022 final regulations continue to apply to taxpayers at this time.
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