IRS offers significant reprieve from FTC regulations

The IRS released guidance on July 21 (Notice 2023-55) providing relief for taxpayers determining whether foreign taxes are eligible to be taken as foreign tax credits (FTCs). The temporary relief primarily defers certain aspects of recent unpopular final FTC regulations that widely curtailed the creditability of certain foreign taxes. The notice will instead allow taxpayers to use a modified version of the rules that existed before the most recent final regulations. However, the relief is generally not extended to certain digital service taxes (DST).

For the relief period, taxpayers can continue to follow a modified version of the prior FTC regulations (in effect as of April 1, 2021) while the IRS revisits and potentially changes final regulations (T.D. 9959) that were released in December 2021 and published in the Federal Register on Jan. 4, 2022 (“2022 FTC Regulations”). The 2022 FTC regulations included several controversial provisions, such as the attribution requirement and a per se cost recovery rule, that rendered many foreign taxes non-creditable.

In light of Notice 2023-55, taxpayers should immediately assess the impact of the optional relief on their tax profile. Many taxpayers may have already analyzed the impact and taken positions under the 2022 FTC Regulations on either their financial statement or their income tax returns. In many cases, the notice may allow FTCs in situations that were not available under the 2022 FTC Regulations. Taxpayers that have already filed returns taking unfavorable positions on creditability under the 2022 FTC Regulations may have opportunities to amend or supersede returns for refund claims where taxes that were deducted that may now be viewed as creditable.

Background

Generally, Section 901 allows a credit for foreign income, war profits and excess profits taxes. Section 903 provides that such taxes include a tax in lieu of a generally imposed foreign income, war profits or excess profits tax. The pre-existing regulations, which remained largely unchanged since their issuance in 1983, set forth rules for determining when foreign taxes qualify under Sections 901 or 903. These prior final regulations treated a foreign levy as an income tax if (i) the foreign levy is a tax and (ii) the predominant character of that tax is that of an income tax in the U.S. sense.

On Jan. 4, 2022, the Treasury and the IRS published the 2022 FTC Regulations, which made several changes to modernize and clarify the regulations to address issues that arose out of changes in global taxation since 1983. In particular, the 2022 FTC Regulations modified the net gain requirement to limit the role of the predominant character analysis in determining whether a tax meets each of the components of the net gain requirement. In addition, the 2022 FTC Regulations also substantially modified the substitution requirement by including four additional requirements (i.e., the generally imposed net income tax requirement, the non-duplication requirement, the close connection requirement and the jurisdiction-to-tax requirement) and separate requirements for covered withholding tax (i.e., the generally imposed net income tax requirement, the withholding tax on nonresidents requirement, the non-duplication requirement, the close connection requirement and the source-based attribution requirement). For additional information on the 2022 FTC Regulations see our prior communication, Final FTC regs address broad range of issues.

After the release of the final regulations, Treasury and the IRS released correcting amendments to the 2022 FTC Regulations and proposed regulations (REG-112096-22), which included proposed rules relating to the cost recovery requirement and the single-country exception for royalty withholding taxes in 2022. On April 17, 2023, Treasury and the IRS published Notice 2023-31, extending the transition period for the single-country exception. See our prior coverage, IRS offers FTC relief for cost-recovery, attribution rules.

Summary of temporary relief

Notice 2023-55 provides the following temporary relief for foreign tax paid or accrued during the “relief period” (discussed below):

1. Taxpayers may apply former Treas. Reg. Sec. 1.901-2 (a) and (b) instead of the existing Treas. Reg. Sec. 1.901-2(a) (definition of foreign income tax) and (b) (net gain requirement), but with a modification to the non-confiscatory gross basis tax rule (discussed further below)
2. Taxpayers may apply existing Treas. Reg. Sec. 1.903-1 without applying Treas. Reg. Sec. 1.903-1(c)(1)(iv) (jurisdiction to tax excluded income) or Treas. Reg. Sec. 1.903-1(c)(2)(iii) (source-based attribution requirement).

Relief period

Taxpayers may apply this temporary relief to foreign taxes paid or accrued in the relief period, provided that the taxpayer satisfies certain requirements (summarized below). The relief period means taxable years beginning on or after Dec. 28, 2021 (i.e., the effective date of the 2022 FTC Regulations), and ending on or before Dec. 31, 2023, and “relief year” is defined as any taxable year within the relief period. The IRS specifically noted that they are considering whether, and under what conditions, to provide additional temporary relief beyond the relief period.

Eligibility requirements

Taxpayers may apply this temporary relief to foreign taxes paid in any relief year, provided that the taxpayer satisfies the following requirements:

• The taxpayer must apply the temporary relief to (1) all foreign taxes paid by the taxpayer in the taxpayer’s relief year, and (2) all foreign taxes (i) that are paid by any other person in a taxable year that begins on or after Dec. 28, 2021, and that ends with or within the taxpayer’s relief year, and (ii) for which the taxpayer would be eligible to claim a credit, as provided in Section 901 (determined without regard to certain limitations described in Treas. Reg. Sec. 1.901-1(b), such as Sections 901(m), 245A(d), etc.), if the taxpayer applied the temporary relief to such foreign taxes. This includes foreign taxes paid by a controlled foreign corporation (CFC) of which the taxpayer is a U.S. shareholder in the CFC’s taxable year that ends with or within the U.S. shareholder’s relief year.
• A member of a consolidated group may apply the temporary relief to a relief year only if all members of the consolidated group apply the temporary relief to the relief year.
• The taxpayer may not apply the temporary relief in a relief year to claim a credit, as provided under Section 901, for any amount of foreign tax for which a deduction is allowed in the relief year or any other taxable year.

Continued non-creditability of digital service taxes

Notice 2023-55 revises the nonconfiscatory gross basis tax rule under the former Treas. Reg. Sec. 1.901-2(b)(4)(i), replacing the existing rule with the following: “[n]o foreign tax whose base is gross receipts or gross income satisfies the net income requirement, except in the case of a foreign tax whose base consists solely of investment income that is not derived from a trade or business, or wage income (or both).” Therefore, under the temporary relief, a foreign country’s DST does not satisfy the net income requirement of former Treas. Reg. Sec. 1.901-2(b)(4)(i), because the base of the tax is gross receipts or gross income and does not consist solely of investment income that is not derived from a trade or business, or wage income.

In addition, the notice indicates that a foreign country’s DST that applies by its terms to any income subject to that foreign country’s net income tax remains noncreditable as a tax in lieu of an income tax because it would fail the non-duplication requirement under Treas. Reg. Sec. 1.903-1(c)(1)(ii) and Treas. Reg. Sec. 1.903-1(c)(2)(ii). See Treas. Reg. Sec. 1.903-1(d)(1) (Example 1).