Ever since 2017’s Tax Cuts and Jobs Act (TCJA) significantly modified certain foreign tax credit rules, the Treasury Department and the IRS have released several versions of proposed and final regulations aimed at helping taxpayers apply the new rules to their circumstances. The latest proposed regulations were issued in November 2022 and are a direct response to taxpayer and practitioner questions that arose from guidance issued in January 2022 (the January guidance). The November 2022 regulations focus on clarifications around issues such as cost recovery and attribution requirements for royalty payments.
For a more detailed discussion on the changes to the foreign tax credit framework, including the addition of the new attribution requirement, please see our August 2022 webinar.
Foreign tax credits for royalty payments
The January guidance contained an attribution requirement that focused on foreign tax rules for sourcing taxing rights on royalties. In practice, this requirement would limit the creditability of royalty withholding taxes paid to many foreign countries. The proposed regulations added a welcomed clarification that credits for withholding taxes on royalty payments could be permitted if the royalty agreement includes language that specifically identifies the intangible property as being used in the country where the tax is being withheld. This documentation requirement, referred to as the single-country use exception, creates what could be considered a form of safe harbor that allows the taxpayer to potentially credit these withholding taxes.
However, there’s an important timeline with this provision. On April 3, 2023, the IRS released Notice 2023-31, which included guidance extending the transition period for this documentation requirement for royalty payments. Notice 2023-31 indicates that updated royalty agreements meeting the requirements must be executed no later than 180 days after the date that the November 2022 regulations are finalized. The IRS hasn’t indicated an expected timeline for finalization, as they’re still considering comments from taxpayers and practitioners. However, this guidance provides additional flexibility compared to the requirements in the November 2022 regulations. There’s only a six-month window to complete any changes once the regulations are finalized, and commercial reasons could require additional time to make necessary changes. Taxpayers should review their royalty agreements now to evaluate and implement any necessary updates. Also, if the royalty agreement currently covers multiple jurisdictions, there is additional guidance to consider.
This exception applies to both intercompany royalty agreements and those made with third parties. Affected taxpayers should consult with their advisors on this to weigh the potential tax benefits of preserving foreign tax credits against other possible impacts, including commercial and transfer pricing considerations, which may result from modifications to long-standing agreements.
Cost recovery under the proposed foreign tax credit regulations
The January guidance provided fairly broad restrictions to foreign tax credit claims due to changes in cost recovery requirements. These requirements have always existed in some form but were changed to require more parity between foreign tax rules and U.S. tax rules. The latest proposed regulations would relieve some of those restrictions by allowing relief where foreign tax rules on allowable deductions deviate from U.S. tax rules but still meet certain safe harbors or conditions, such as:
- A tax would be considered qualified for foreign tax credit if the foreign tax rules result in 25% or less of significant expenses becoming limited or nondeductible.
- Taxpayers that qualified to deduct an amount of significant expenses up to 30% or more of taxable income or 15% or more of gross receipts would also qualify for foreign tax credits.
- Lastly, the proposed regulations allowed for principle-based exceptions where an expense might be permanently nondeductible in the foreign jurisdiction but would also be nondeductible under U.S. rules (e.g., thin capitalization, limits on deductions of executive compensation).
These proposed regulations eased some of the concerns expressed in comments that the January guidance would cause many taxpayers to see significant reductions in their foreign tax credits; however, significant analysis is required and is the responsibility of the taxpayer. The IRS has indicated they don’t plan to issue additional guidance that would provide a list of nonconforming countries or taxes.
Remaining ambiguities could lead to additional foreign tax credit guidance
While the guidance was welcomed, more guidance and safe harbors would be desired, particularly given the complexity of the rules. The burden to fully understand and evaluate foreign tax rules to secure foreign tax credits will significantly impact many taxpayers, in addition to the potential for increased instances of double taxation on foreign income and increased cash taxes.
There remains uncertainty about the impact of the guidance on individual taxpayers. The amount of taxes that may flow through to an individual and the resources required to evaluate foreign tax rules for creditability could prove burdensome. The IRS continues to receive comments regarding the application of the regulations to individuals.
Additionally, the impact on controlled foreign corporations of U.S. shareholders is in question. In countries where the conditions of the regulations are not met, treaty positions likely aren’t available to preserve the creditability of foreign taxes. Therefore, taxes paid by controlled foreign corporations (in particular, withholding taxes) may be permanently noncreditable even after considering the November guidance.
Some countries are particularly challenging when it comes to foreign tax credits
Certain regions may present a higher hurdle to clear to continue to credit foreign taxes. In many cases, South and Central American countries, especially countries that aren’t members of the Organization for Economic Co-operation and Development (OECD) and whose tax laws may not adhere to OECD transfer pricing and taxation guidelines, won’t meet the attribution requirements necessary to qualify for these rules.
Brazilian corporate income tax, for instance, doesn’t meet attribution requirements because of its current transfer pricing rules; but the country is currently considering joining the OECD, which would include aligning transfer pricing rules to the OECD standard of arm’s length. Due to this potential move, taxpayers and practitioners have asked the IRS to delay these regulations — specifically with respect to Brazil — but such a delay hasn’t been implemented. There are concerns that Brazil taxes could be subject to one set of rules for 2022 and another set in 2023 if it joins the OECD.
What does this guidance mean for affected taxpayers?
Even with welcome relief in the latest proposed rules, taxpayers should be prepared to document and support their positions on the creditability of foreign taxes for tax returns filed for tax years 2022 and beyond.
Taxpayers who may qualify for the single-country use exception for royalty payments should review their agreements to make sure they meet the requirements in the regulations. The shortened time frame to implement documentation requirements needed to meet this exception suggests that agreements should be reviewed for compliance as quickly as possible in the event they may require amending.
To learn more about how the latest guidance on foreign tax credits could affect your tax position, please contact your Plante Moran advisor.
