On July 23, 2023, taxpayers, both domestic and abroad, anxious about claiming foreign tax credits on this year’s return, were provided a respite. The IRS released Notice 2023-55, which walked back the most recently released proposed regulations debuted in November 2022. Regulations the tax industry had expressed much concern over. The new rules for foreign tax credits appeared to disqualify many foreign income taxes from being creditable in the United States.
Relief comes for tax years 2022 and 2023. Previous rules will be allowed on the creditability of withholding tax on royalties from non-treaty countries and net income versus cost recovering basis for determining a creditable foreign tax (e.g., Brazil). This includes foreign taxes, paid by a controlled foreign corporation, which had been limited by the new regulations.
This relief does not apply to any digital services tax that are still being proposed by certain taxing jurisdictions, including Canada.
Withholding Tax on Royalties-Non-Treaty Countries
For a foreign tax based on income arising from sources within the foreign country, the new regulations required foreign tax laws to be reasonably akin to U.S. sourcing rules. Income from services must be taxed where the services are performed, not where the recipient is located. Royalty income must be sourced to the place of use or right of use, and not from where paid. Treaty protection was afforded to those countries with which the United States had a treaty, but non-treaty country withholding taxes would not have been creditable. Single-source country agreements were a workaround, but now that will not be required during the relief period.
Expansion of Arms-Length Requirement
For residents of a foreign country imposing destination-based taxes, the new regulations required any allocation made under the foreign country’s transfer pricing rules must be determined under arm’s length principles. It was irrelevant whether taxpayers apply arm’s length principles in their transactions or even engage in related-party transactions. Creditability was denied where the foreign country’s transfer pricing rules, as generally applicable to all taxpayers, do not adopt arm’s length principles or where those rules use destination-based criteria. For example, Brazil is a country often cited as having this problem.
We can once again use the old regulations, which did not consider whether a country used arm’s length principles, in considering whether the foreign taxes are creditable. Fortunately, Brazil has been moving forward with changes that might avoid this problem in the future.
Creditable Foreign Taxes-Net Income Requirement
Under old regulations, a foreign levy was considered an income tax if "the predominant character of that tax is that of an income tax in the U.S Sense." A foreign tax was considered to have a predominant character of an income tax in the U.S. Sense if it was likely "to reach net gain in the ordinary circumstances in which it applies." The cost recovery requirement replaced the net income requirement. We now temporarily revert to the net income tax concept.
New regulations provided a foreign tax was creditable only if the tax was based on gross receipts that allowed for cost recovery (in other words, a deduction) for costs and expenses, including:
- Capital expenditures
- Interest, excluding limitations similar to Section 163(j)
- Rents, royalties, wages or payments for services
- Research and experimentation
The character of a deduction was determined under foreign law. Foreign tax law satisfied this requirement even when deductions were disallowed for all or a portion of an expense, provided the disallowance was consistent with principles underlying disallowances required under U.S. rules.
For example, the foreign tax may limit interest deductions so as not to exceed 10% of a reasonable measure of taxable income, based on principles similar to those underlying Sec. 163(j).
These rules may eventually come back into play after 2023, but it is presently unclear what may occur since the Treasury states in the Notice they have an ongoing period of analysis and, …” are considering whether, and under what conditions, to provide additional temporary relief beyond the relief period.”
How Does This Impact Your Operations?
Moore Doeren Mayhew has been working with clients on these issues, especially in connection with how to file their 2022 tax returns due this fall. If you have questions, please contact one of our international tax advisors today.
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