An Update On The Foreign Tax Credit Rules And IRS Relief

Tax Notes reporter Andrew Velarde discusses the latest developments on the final regulations for claiming foreign tax credits, including the IRS’s decision to delay implementation and the tax community’s response.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: a welcome delay.

In July the IRS announced a temporary reprieve to the implementation of new foreign tax credit regulations. So what effect will this delay have, and what does it mean for future guidance? Tax Notes senior legal reporter Andrew Velarde will talk about that in just a minute.

Later in the episode, we’ll hear from Tax Notes Federal author Christopher Moran about how the proposed energy credit regulations would decrease investment in renewable energy projects.

But first, Andrew, welcome back to the podcast.

Andrew Velarde: Thanks, Dave. It’s good to be here.

David D. Stewart: Could you start off with a bit of background on what’s been going on in foreign tax credits before this most recent guidance?

Andrew Velarde: Sure. I think a little level setting would be beneficial to understand why the IRS may have felt the need to issue its most recent notice, which came in July.

Now, bear with me here. Let’s go back to January 2022. That’s when the IRS and Treasury released final foreign tax credit regs that substantially changed the rules for determining whether a foreign tax is creditable. Those rule changes were made to address novel extraterritorial taxes that split from U.S. rules and “abandoned international norms” — namely, digital services taxes.

The final regs clarify that there are four aspects to a creditable tax: realization, gross receipts, cost recovery, and attribution. But taxpayers were strongly critical of the rules, arguing they went far beyond the targeted digital services taxes and could deem many taxes non-creditable.

The attribution and cost recovery requirements in particular were the subject of a lot of taxpayer criticism. With its source rule, the attribution requirement demands that foreign-tax-based amounts be limited to sources inside a country with source rules functioning like those of the United States.

Now, some argued that royalties and payments for services performed outside the taxing jurisdiction could fail to meet the source-based attribution requirement. Cost recovery requires that tax base be reduced by significant costs attributable under reasonable principles to gross receipts.

Critics argued that analyzing cost recovery would require an examination of whether expenses are significant and a knowledge of local law that taxpayers and the IRS lack. It might also create a cliff effect because if the IRS or taxpayer determines that a foreign tax law doesn’t allow for the recovery of a significant expense and that denial is inconsistent with the U.S. code, the entire foreign tax is not creditable.

The government went about trying to address some of these worries from the final regs, first with technical corrections, and then with proposed regs in November 2022. These proposed regs provided a single-country royalty withholding carveout and a cost recovery safe harbor. The carveout allows creditability — even when foreign tax rules don’t follow the code [and] instead source royalties based on residence — if a taxpayer has licensed intangible property that is used only in the foreign jurisdiction where the licensee is a resident.

David D. Stewart: Now, do these new regs address the problems that some taxpayers had had with the old ones?

Andrew Velarde: Not entirely. Taxpayers and practitioners were certainly pleased with the changes in the proposed regs, but many felt they didn’t go far enough.

For instance, they asked Treasury to expand the single-country royalty withholding carveout to also apply to services. Initially, Treasury’s reaction to this seemed to be cool at best, but later in June the IRS said it would welcome comments on situations where such an exception for services would be appropriate.

The FTC regs — the final regs now — also caught the eye of lawmakers. In June House Ways and Means Republicans voted to advance the Build It in America Act (H.R. 3938), which would allow U.S. companies to ignore the FTC regs.

David D. Stewart: So that brings us now to July and the latest notice from the IRS. So what did they do?

Andrew Velarde: That’s right, Dave. So on July 21 the IRS issued Notice 2023-55, which provides temporary relief from its FTC rules. This one came as a surprise to the practitioners I spoke with, notwithstanding the criticism and the legislation I just told you about. There’s not a lot of substantive analysis to it; it’s only five pages long, but it could have a huge impact for taxpayers.

Essentially, the notice states that for tax years beginning on or after December 28, 2021, and ending on or before December 31, 2023, taxpayers in most situations can apply the old rules for sections 1.901-2(a) and (b) on the definition of foreign income tax and the net gain requirement.

But no foreign tax based on gross receipts or gross income satisfies the net income requirement unless its base is solely investment income not from a trader business or wage income. So DSTs will continue to be uncreditable, and taxpayers can apply the existing reg section 1.903-1 without applying the jurisdiction to tax excluded income or source-based attribution requirement.

The relief can be applied to any relief year if taxpayers apply it to all foreign taxes paid in the year, including taxes paid by controlled foreign corporations. All consolidated members must apply the temporary relief to be eligible.

It’s a rather unusual move, according to the practitioners I talked to. The regs have not been withdrawn, but the notice may be a harbinger of future changes. It states that analysis is still ongoing and additional temporary relief or amendments to the 2022 final regs may still be coming.

The government has said that it issued the notice because of legitimate concerns about intended consequences from the final regs and the realization that follow-up guidance couldn’t address all these concerns as quickly as they would like.

Practitioners have praised the notice as an acknowledgment from the government that the FTC rewrite may have swept far more broadly than the project’s original intent to address DSTs.

David D. Stewart: So we’ve heard from practitioners; have we also heard from the business community about this notice?

Andrew Velarde: Yes. It’s getting a fair amount of attention from big multinationals, as is evident by a number of specific mentions in recent SEC quarterly filings from some of these companies. Its exact dollar impact is still being evaluated in many circumstances, although a few companies have put a number on it. Johnson & Johnson, for example, said delaying the FTC rules until 2024 would result in recording a tax benefit of a half a billion dollars. And VMware, the cloud computing company, recorded a $60 million tax benefit earlier this month.

David D. Stewart: All right, so we’ve got a great ending for these companies, then.

Andrew Velarde: Well, yes and no. Not quite just yet. They were undoubtedly pleased with the delay, but companies were quick to ask the IRS and Treasury to go further.

In August the Silicon Valley Tax Directors Group said the notice may have provided “much-needed breathing room” to evaluate FTC developments, but that the government should extend the temporary relief and possibly even withdraw the regs entirely and propose new ones.

This is a significant taxpayer advocate group for the tech industry. They have $2.8 trillion in revenue and includes household names like Amazon, Apple, Disney, and Microsoft, just to name a few. It argues that how to apply the 2022 FTC final regs to foreign taxes is very murky and the relief period may not be adequate, especially for fiscal-year taxpayers who are now subject to the final FTC regs for their 2024 fiscal year and need to make quarterly financial statement filings accounting for FTCs.

And the government, for its part, seems to be listening. Although we haven’t had a further extension just yet, earlier this week the IRS revealed that it planned on extending the relief for fiscal-year taxpayers who may not be covered by the relief period in the notice and that they anticipate extending the relief for another year.

David D. Stewart: We have a delay. Are we expecting additional guidance from the IRS?

Andrew Velarde: Yes. Also a few days ago, Treasury said it hopes to release FTC guidance related to pillar 2 by year-end. Pillar 2 relates to the OECD’s global anti-base-erosion rules and establishes a top-up tax for large multinationals with revenue of more than €750 million to make sure they’re paying a 15 percent effective tax rate in all jurisdictions where they operate.

Treasury and the IRS have said that they are working on these FTC regs alongside the notice extension, and the regs will relate to taxes paid under pillar 2’s income inclusion rule, the undertaxed profits rule, and the qualified minimum top-up taxes.

David D. Stewart: Well, it sounds like there’s a lot of moving parts to keep track of. Thank you for giving us an update on them, and thank you for being here.

Andrew Velarde: Thank you, Dave. It’s good to be here.