IRS addresses Pillar 2 and expands FTC relief

The IRS released guidance on Dec. 11 (Notice 2023-80) that extends relief from recent foreign tax credit (FTC) regulations and addresses the treatment of Pillar 2 taxes for FTCs, the dual consolidated loss DCL rules (DCL), and Global Intangible Low-taxed Income (GILTI).

Key elements of the Pillar 2 global minimum tax regime from the Organisation for Economic Co-operation and Development (OECD) are scheduled to begin taking effect across many member countries beginning in 2024. The new notice provides guidance on the U.S. treatment of the Income Inclusion Rule (IIR), Undertaxed Profits Rule (UTPR) and Qualified Domestic Minimum Top-Up Tax (QDMTT). The IRS intends to incorporate the guidance in future proposed regulations, but taxpayers can generally rely on the guidance until proposed regulations are published.   

The notice also extends the relief period deferring core aspects of recent unpopular final FTC regulations that widely curtailed the creditability of certain foreign taxes. The final regulations were issued on Jan 4. 2022, but their implementation was later delayed under Notice 2023-55, which allows taxpayers to use a modified version of the rules that existed before the most recent final regulations (with the exception of digital service taxes, see our prior coverage: IRS offers significant reprieve from FTC regulations). Notice 2023-80 now extends that relief.

U.S. multinationals that will be affected by Pillar 2 should immediately assess the impact of the guidance. One of the most significant rules provides that an IIR will generally not qualify for an FTC for U.S. federal income tax purposes. However, this was paired with welcome relief that, in many cases, may allow FTCs in situations that were not available under the 2022 FTC regulations (T.D. 9959). Taxpayers that have already filed returns taking unfavorable positions on creditability under the 2022 FTC regulations may have opportunities to amend returns for refund claims where taxes that were deducted that may now be viewed as creditable.

Background

The Pillar 2 rules create a coordinated system of minimum taxation intended to ensure that Multinational Enterprise Groups (“MNE Groups”) with annual revenue of 750 million euros or more pay a minimum level of tax on the income arising in each jurisdiction in which they operate. An in-scope MNE Group must calculate its effective tax rate in each jurisdiction in which it operates using the Pillar 2 rules. If the effective tax rate for a jurisdiction is below the 15% minimum rate, a top-up tax may be imposed and collected under one of the three following interlocking rules aimed at reducing profit shifting and base erosion:

• Income inclusion rule: The IIR imposes a top-up tax at the parent-entity level that effectively allows countries to “top up” the tax on earnings of foreign subsidiaries with effective rates below 15%.
• Undertaxed profit rule: The UTPR will generally deny deductions with respect to members of a group or otherwise impose mechanisms that will impose additional tax on income subject to an effective rate below 15% that is not otherwise subject to an IIR or QDMTT.
  
• Qualified domestic minimum top-up tax: The QDMTT is a domestic “top-up” tax that will take precedence over either an IIR or UTPR and tax domestic entities up to 15% before another country’s UTPR or IIR applies.
  

Presently, there are no enacted laws incorporating Pillar 2 in the U.S. Additionally, proposed legislation aimed at aligning the U.S. with Pillar 2 has reached a standstill in Congress. While the implementation of Pillar 2 legislation in the U.S. remains uncertain, the pressure to act may intensify as other countries implement crucial components of Pillar 2 in 2024 and 2025. Despite U.S. inaction, the implementation abroad will affect U.S. MNEs in various ways. The rules discussed below address the repercussions of foreign jurisdictions enacting these rules on various aspects of the U.S. federal income tax rules.

Treatment of IIRs, UTPRs and QDMTTs

The notice addresses the treatment of Pillar 2 related foreign taxes for purposes of Sections 59(l), 78, 275, 704, 901, 903, 951A, 954, and 960. The guidance provides that each IIR, UTPR, and QDMTT imposed by a foreign country is considered a “separate levy” within the meaning of Treas. Reg. Sec. 1.901-2(d) from any other levy imposed by that country, even if the country imposes the IIR, UTPR, or QDMTT by adjusting the base of any other levy (such as through an addition to income or denial of deductions). As a result, each tax must be tested separately as to whether it is an income tax for FTC purposes under Sections 901 or 903.

The notice provides that no credit under Sections 901 or 59(l) is allowed to a taxpayer for a “final top-up tax” when, under foreign law, any amount of U.S. federal income tax liability would be taken into account in computing the final top-up tax. This is true regardless of whether the taxpayer paying the final top-up tax has any amount of U.S. federal income tax liability taken into account in such a computation.

A foreign income tax meets the definition of a “final top-up tax” if the computation of such tax under foreign law takes into account either:

• Tax imposed on the direct or indirect owners of the entity paying the tax by other countries (including the United States) with respect to the income subject to the tax, or
  
• In the case of an entity subject to top-up tax on income attributable to a foreign branch of such entity, the amount of tax imposed on the entity by its country of residence with respect to such income.     

The notice provides that a top-up tax will generally be treated as if it were a current-year creditable tax at the controlled foreign corporation (CFC) or partnership level. However, the final top-up tax is not considered for purposes of determining whether the high-tax exception or high-tax exclusion applies in calculating Subpart F and GILTI. Top-up taxes will be included in any Section 78 gross-up, which disallows a foreign tax deduction by grossing-up CFC income when a U.S. corporation credits rather than deducts foreign taxes. The net result of the guidance is that U.S. MNE groups subject to a final top-up tax will not be allowed a credit for the foreign tax, but will still be required to gross-up U.S. taxable income for the foreign tax, thereby denying a deduction at the U.S. level. 

The notice does not address the creditability of the UTPR and indicates that IRS continues to analyze issues related to the UTPR. The IRS intends to issue additional guidance on the UPTR in the future.  

The notice provides rules for determining the creditability of a QDMTT that has been computed based on the income of multiple persons under the jurisdictional blending approach. Taxes paid under the QDMTT regime are allocated to each person using a formulaic approach referred to as the “QDMTT Allocation Key.” A person’s QDMTT Allocation Key is generally the product of

• The excess (if any) of the QDMTT Rate over the person’s Separate Pre-QDMTT ETR, and
• The person’s “Separate QDMTT Income” (i.e., income or loss of the person that is taken into account under the foreign tax law for purposes of computing the QDMTT).

It is anticipated that the proposed regulations on these rules will apply to taxable years ending after Dec. 11, 2023. However, a taxpayer may rely on the rules addressing final top-up taxes and QDMTTs for tax years that end after Dec. 11, 2023, and on or before the date proposed regulations are published in the federal register, provided that the taxpayer consistently follows the guidance in its entirety for all those taxable years.

Dual consolidated losses

Section 1503(d) and the regulations thereunder (the DCL rules) prevent “double-dipping” of losses, which occurs when the same economic loss offsets or reduces both income subject to U.S. tax (but not a foreign jurisdiction's tax) and income subject to the foreign jurisdiction's tax (but not U.S. tax). The DCL rules address this by generally disallowing a DCL to offset or reduce U.S. tax unless an exception is met. Exceptions do not preclude the future disallowance of a DCL, and the DCL rules define triggering events which would result in a DCL previously used to offset U.S. tax to be recaptured into taxable income.

In calculating the jurisdictional effective tax rate under the Pillar 2 rules, a blending approach is applied under which all income and loss of group-entities within the same jurisdiction is aggregated. This aggregation could give rise to the “double-dipping” concerns that the DCL rules were intended to address.

The IRS has provided that they will continue to study the interaction of the DCL rules and Pillar 2 rules. However, in advance of more detailed proposed rules, the notice provides guidance with respect to “Legacy DCLs.” Legacy DCLs are defined in the Notice to include those incurred:

• In tax years ending on or before Dec. 31, 2023, or
• In tax years beginning before Jan. 1, 2024, and ending after Dec. 31, 2023, provided the taxpayer’s taxable year begins and ends on the same dates as the fiscal year of the MNE Group that could take into account as an expense any portion of a deduction or loss comprising such a DCL.

Under this proposed rule, a triggering event will not occur with respect to a Legacy DCL solely because a portion or all of the Legacy DCL is taken into account in determining income in a jurisdiction under the Pillar Two rules. However, an anti-abuse rule will prevent this proposed rule from applying to any DCL that was incurred or increased with the intent of reducing the IIR tax.

Extension and clarification of relief from FTC regulations

The IRS published final regulations (T.D. 9959) on Jan. 4, 2022, rewriting many of the rules for addressing the creditability of taxes under Section 901 and 903. The IRS later released correcting amendments and new proposed regulations altering the previously finalized regulations, but they remained deeply unpopular. Notice 2023-55 was issued on July 21, 2023, to provide temporary relief from the application of core aspects of these rules for determining whether a foreign tax is creditable under Sections 901 and 903. 

Notice 2023-55 originally applied only to foreign taxes paid in any taxable year beginning on or after Dec. 28, 2021, and ending on or before Dec. 31, 2023. Notice 2023-80 now modifies the relief period so that the relief provided by Notice 2023-55 is extended to apply to all tax years beginning on or after Dec. 28, 2021, and ending before the date that notice or other guidance withdrawing or modifying the temporary relief is issued (or any later date specified in such notice or other guidance). Thus, taxpayers may continue to rely on the relief extended under Notice 2023-55 for taxes paid in tax years ending before the temporary relief is withdrawn or modified. 

Notice 2023-80 also clarifies how a partnership and its partners apply the relief provided in Notice 2023-55. The notice clarifies that with respect to foreign taxes paid or otherwise required to be reported by a partnership, the relief would be applicable at the partnership level. Special rules are provided for partnerships and partners in situations where the partnership did not apply the temporary relief for a tax year ending on or before Dec. 31, 2022, as well as rules addressing the consistent application of the rules for partnerships and their partners.