The U.S. Department of the Treasury and the IRS published Notice 2023-55 on July 21 to provide temporary relief from the application of the FTC regulations published on Jan. 4, 2022 (2022 final regulations) when determining foreign tax credit eligibility under Sections 901 and 903. Even after publication of several clarifications of the 2022 final regulations, significant questions remain. Notice 2023-55 provides welcome relief from having to apply the 2022 final regulations while Treasury and the IRS work on guidance to address these questions.
Section 901 allows a credit against U.S. income taxes for the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the U.S. Section 903 provides that the credit in Section 901 also applies to tax paid in lieu of tax on income, war profits, or excess profits otherwise generally imposed by any foreign country or by any possession of the U.S. (for instance, a withholding tax on payments to a nonresident). Prior to the amendments made by the 2022 final regulations, a foreign levy was treated as an income tax eligible for a credit if the foreign levy was a tax and if the tax had the predominant character of an income tax in the U.S. sense. The predominant character of the foreign tax was determined based on a three-part net gain requirement, which included tests to establish realization, gross receipts, and net income.
The 2022 final regulations significantly narrowed the scope of foreign taxes eligible for a credit against U.S. tax liabilities under Sections 901 and 903 for tax years beginning on or after Dec. 28, 2021. Under a newly added attribution requirement, for a foreign tax to be treated as creditable, the foreign country’s sourcing rules applicable to nonresidents must align with the sourcing rules under U.S. tax law. The 2022 final regulations also replaced the net income requirement under the former FTC regulations with a cost recovery requirement that is met only if the foreign tax law allows for the recovery of significant costs and expenses attributable to gross receipts.
Taxpayers and their advisers raised concerns that the 2022 final regulations were too restrictive. For example, because many countries impose withholding taxes on royalties based on the residence of the payer while the U.S. tax law sources royalty income based on where the intangible property is used, such withholding taxes are not creditable under the new attribution rule of the 2022 final regulations.
Two sets of technical corrections to the 2022 final regulations were published on July 27, 2022. Proposed regulations published on Nov. 22, 2022, provide safe harbors to ease the cost recovery requirements and limited relief from the source-based attribution requirement for withholding tax on royalties on property with a license for use in a single country. On April 3, Notice 2023-31 was released announcing an extension of time for compiling certain documentation required to qualify for the single-country exception of the proposed regulations. However, these updates did not address all the concerns raised with respect to the 2022 final regulations.
Notice 2023-55 provides taxpayers with temporary relief from having to apply the 2022 final regulations in determining whether foreign taxes paid are creditable under Sections 901 and 903. The relief is applicable to foreign taxes paid in tax years beginning on or after Dec. 28, 2021, and ending on or before Dec. 31, 2023. Any tax year within the relief period is referred to as a relief year.
Under the temporary relief, taxpayers may elect to apply former Treasury Regulation Sections 1.901-2(a) and (b) as in effect before the 2022 final regulations with certain modifications to tax years in the relief period. In other words, taxpayers can claim a credit for foreign taxes that meet the net gain requirements under former FTC regulations without having to apply the attribution requirement and the cost recovery requirement under the 2022 final regulations.
Separately, with respect to withholding taxes, taxpayers can elect to apply Treasury Regulation Section 1.903-1 without the source-based attribution requirement. For taxpayers to claim foreign tax credits on withholding taxes, the sourcing rules of the foreign country do not need to align with the sourcing rules under U.S. tax law.
Taxpayers that elect to apply the relief of Notice 2023-55 no longer need to rely on the rules of the proposed regulations within any relief year, such as the single-country license exception or the safe harbors for the cost recovery requirement.
A taxpayer may apply the relief not only to foreign taxes it paid in a relief year but also to those paid by any other person (including a controlled foreign corporation) for which the taxpayer is entitled to claim a credit in a taxable year corresponding to the relief period.
A taxpayer does not have to apply the temporary relief for the entire relief period but must consistently apply it within a given relief year. For a consolidated group, all group members must consistently elect to apply the temporary relief to a relief year.
Under the notice, foreign taxes imposed on gross receipts or gross income fail the net income requirement under former FTC regulations, with an exception for taxes with a base consisting solely of passive types of investment income or wage income. The notice specifically excludes digital services taxes from the scope of relief, clarifying that the base of such taxes does not fall within the exception.
Because the relief period applies to tax returns that already have been filed, amended returns (or administrative adjustment requests) might be required to take advantage of the relief.
Notice 2023-55 provides welcome relief to taxpayers. However, it is unclear what the next iteration of FTC regulation updates will look like. Consequently, taxpayers should consult with their tax advisers to assess whether to apply the relief in Notice 2023-55 for relief years and to evaluate the financial statement impact of applying the relief. Taxpayers also should stay focused on their FTC profile to understand how changes to FTC regulations might affect them going forward.
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