Executive summary: Taxpayers receive relief
The IRS and Treasury have granted taxpayers temporary relief (the relief) under sections 901 and 903 in determining whether a foreign tax qualifies as a creditable tax for purposes of the foreign tax credit (FTC). Notice 2023-55, issued July 21, 2023, gives taxpayers the option to temporarily apply:
- Former section 1.901-2(a) and (b) (i.e., before T.D. 9959), for the definition of a foreign net income tax and for purposes of satisfying the net gain requirement, but subject to a modified non-confiscatory gross basis tax rule, and
- Existing section 1.903-1 without the jurisdiction to tax excluded income and attribution requirements.
The relief applies to tax years beginning on or after Dec. 28, 2021, and ending on or before Dec. 31, 2023 (e.g., 2022 and 2023 calendar years).
Temporary relief granted for the foreign tax credit
Creditability of foreign taxes
In 2022, Treasury and the IRS released final regulations (T.D. 9959), a set of technical corrections, and proposed regulations all aimed at addressing the creditability of foreign income taxes for purposes of the FTC. These new rules are generally applicable to foreign income taxes paid or accrued in tax years beginning on or after Dec. 28, 2021 (e.g., 2022 calendar year taxpayers) and have wide-reaching impacts.
In general, a taxpayer can only claim an FTC to the extent a tax is considered creditable under sections 901 and 903. Section 901 allows a credit for foreign income, war profits and excess profits taxes, whereas section 903 provides that such taxes include a tax in lieu of a generally imposed foreign income, war profits or excess profits tax. Up until the issuance of the final regulations, a foreign levy was an income tax if and only if:
- it was a tax; and
- the predominant character of that tax was that of an income tax in the U.S. sense
The predominant character "test" was met if the tax:
- was likely to reach net gain in the normal circumstances in which it applied (the net gain requirement), and
- was not a “soak-up” tax
To satisfy the net gain requirement, a foreign tax needed to meet three sub requirements: realization, gross receipts and net income.
The final regulations revised the net gain requirement, ensuring that a foreign tax is only a creditable net income tax if the determination of the foreign tax base conforms in essential respects to the determination of taxable income under the Code. This effectively shifts the definition of a creditable tax from an income tax (i.e., a tax on income) to being a tax that is sufficiently similar to the Code. Under these new rules, a foreign tax will only satisfy the net gain requirement if the tax satisfies four sub-requirements: realization, gross receipts, cost recovery (i.e., formerly the net income requirement), plus a new attribution requirement. The final regulations further stipulate that determining whether a foreign tax satisfies each component of the net gain requirement is generally based on the terms of the foreign tax law governing the computation of the tax base rather than empirical analysis. The final regulations maintain the long-standing all-or-nothing rule. A foreign tax either is or is not a foreign income tax, in its entirety, for all persons subject to the foreign tax.
Satisfying the revamped cost recovery and new attribution requirements require consultation with local country tax experts and an in-depth knowledge of foreign tax law. More often than not, this analysis is rigorous and time consuming. Taxpayers and tax professionals alike have raised concerns that historically creditable taxes may no longer be creditable under these new rules. They have been relentlessly harping on Treasury and the IRS to modify the latest guidance.
Notice 2023-55 relief
Notice 2023-55 provides taxpayers with a significant break just in the nick of time for the upcoming tax filing season. Taxpayers may apply this relief only if they satisfy certain criteria. The taxpayer must apply the relief to:
- All foreign taxes paid by the taxpayer in the taxpayer’s relief year, and
- 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 the limitations described in section 1.901-1(b)), if the taxpayer applied the temporary relief to such foreign taxes.
The criteria further specifies that:
- Foreign taxes paid by the taxpayer include 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,
- All members of a consolidated group must be consistent in their approach, and
- The taxpayer may not apply the relief in a relief year to claim a credit for any amount of foreign tax for which a deduction is allowed in the relief year or any other taxable year.
Under the relief, a digital services tax (DST) will continue to fail the net income requirement under section 901.
This notice is proof that Treasury and the IRS are listening to taxpayer concerns and hearing them out. The notice mentions that Treasury and the IRS “continue to analyze issues related to the final regulations and are considering proposing amendments to those regulations.” They “are considering whether, and under what conditions, to provide additional temporary relief beyond the relief period.”
The provisions described in this alert are subject to change in any finally enacted regulation package. Nonetheless, taxpayers should contact their advisors to better understand how Notice 2023-55 may affect their tax obligations.