On July 21, 2023, the IRS released welcomed temporary relief related to 2022 final foreign tax credit regulations (the 2022 regulations), which have caused widespread concern from taxpayers about the ability of foreign tax credits to offset double taxation.
The new guidance (Notice 2023-55) provides a temporary two-year relief period from the 2022 final regulations. During this period, taxpayers may determine a creditable tax based on prior foreign tax rules before the changes in the 2022 regulations. For most taxpayers, this is a favorable development that will benefit their foreign tax credit positions for 2022 and 2023 tax years.
Background on the foreign tax credit regulations
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 combined effect of the 2022 guidance was to amend the definition of a creditable foreign income tax in Sections 901 and 903. Sec. 901 allows a credit for foreign income, war profits, and excess profit taxes, while Sec. 903 allows a credit for taxes paid in lieu of an income tax (i.e., withholding taxes). The addition of an attribution requirement and changes to the cost recovery requirement led to much doubt about the creditability of many types of foreign taxes within the updated rules.
For example, withholding taxes on royalty and services payments paid to many countries, and direct income taxes paid to certain nontreaty countries (such as Brazil), face significant challenges to satisfy the rules in the 2022 regulations. As a result, some taxpayers wouldn’t have been able to claim a credit on certain foreign taxes beginning with their 2022 tax years without additional guidance or relief from the IRS.
Summary of Notice 2023-55
The following changes are included in the temporary relief:
- Taxpayers can now apply former regulation Sec. 1.901-2(a) and (b) instead of the November 2022 1.901-2(a) and (b). This change reverts the rules defining a foreign income tax (i.e., taxes that are eligible for a credit) back to the former rules before the 2022 regulations. As a result, most issues raised by taxpayers in connection with the 2022 regulations will be deferred for 2022 and 2023.
- Taxpayers can apply former regulations Sec. 1.903-1 without the application of the attribution requirement. Similar to the above, this change reverts the rules defining a creditable withholding tax to the former rules before the 2022 regulations. As a result, issues related to taking a foreign tax credit position on many withholding taxes (such as taking steps to meet single-country license requirements) are deferred for 2022 and 2023.
- Specific language added regarding any “foreign tax whose base consists solely of investment income that isn’t derived from a trade or business, or wage income (or both). This new language in the temporary regulations ensures that digital service taxes (DSTs) are ineligible for foreign tax credits during 2022 and 2023 tax years.
Foreign tax credit relief period
The relief period is defined to include any taxable years beginning on or after Dec. 28, 2021, and ending on or before Dec. 31, 2023. Therefore, calendar year taxpayers will benefit from this temporary relief for both the 2022 and 2023 tax years. Fiscal year taxpayers should carefully analyze their applicable relief period and will likely not be able to apply the temporary relief for 2023 tax years.
Scope of relief for foreign tax credits
Taxpayers who apply this temporary relief must apply the rules consistently for all foreign taxes paid during the relief period and to all foreign taxes for which the taxpayer is eligible for a credit, including foreign income taxes paid by controlled foreign corporations and members of a consolidated group.
Next steps for taxpayers regarding foreign tax credits
The Treasury Department and the IRS have received extensive questions and requests for modifications since the 2022 regulations were released, and this temporary relief acknowledges the challenges experienced by taxpayers in applying the regulations. The notice indicates that the IRS and Treasury will continue to consider future changes to the 2022 regulations. Taxpayers should monitor these developments in case of further guidance.
Taxpayers should also assess the impact of the temporary relief on their foreign tax credit position. For many taxpayers, the changes will be favorable by allowing creditability positions determined in prior years to be continued. For fiscal year taxpayers, while the relief is welcome overall, the application of the relief period should be closely analyzed, including the impact on financial statement positions and the level of documentation required to take a foreign tax credit position.
