House Republicans this week won the minimum 218 seats needed to secure a majority in the 118th Congress when it convenes in January 2023; House Republicans are expected to hold a slim majority when the final outstanding elections are called. Democrats will control the Senate, though whether the ratio is 51-49 or 50-50 depends on the outcome of the 6 December Georgia runoff election, with divided government expected to damper legislative activity for the next two years, although bipartisan legislation is possible.
Congress is back in session following the election, but the outlook for the lame-duck session remains unclear. While there appears to be bipartisan support for addressing the Tax Cuts and Jobs Act (TCJA) Section 174 amortization requirement, Democrats are insistent that a Child Tax Credit expansion be part of any tax package, which could also address the Internal Revenue Code1 Section 163(j) interest deductibility calculation, expensing, and the nonitemizer charitable deduction that was in effect for 2021.
There is no indication yet if the full Senate will take up the proposed United States (US)-Chile income tax treaty during the lame-duck session. The Senate Foreign Relations Committee approved the proposed accord on 29 March 2022.
The US Treasury on 18 November released proposed regulations (REG-112096-22 (pdf); Proposed Regulations) on foreign tax credits. The Proposed Regulations would amend the final foreign tax credit regulations published on 4 January 2022 (TD 9959; Final Regulations, as amended by technical corrections to those regulations published on 27 July 2022). Highlights of the Proposed Regulations include the following:
- The Proposed Regulations would significantly relax the cost recovery requirement by providing that a foreign tax law need only allow for recovery of “substantially all” of each item of significant cost or expense, regardless of what the principles underlying any disallowances are. This “substantially all” determination would apply based on the foreign tax law (not a particular taxpayer’s individual facts).
- For purposes of applying the “substantially all” test, the Proposed Regulations introduce two safe harbors. The first would treat the foreign tax as not failing the “substantially all” test if the underlying foreign tax law disallows no more than 25% of one or multiple cost items. The second safe harbor would treat the foreign tax as not failing the “substantially all” test if the underlying foreign tax law limits recovery of a single item of significant cost or expense or multiple items within a single category of per se significant costs or expenses based on a “qualifying cap.” A qualifying cap is defined as a foreign tax law that caps cost recovery based on no less than 15% of gross receipts, gross income, or a “similar measure.” A qualifying cap also includes a foreign tax law that caps cost recovery based on no less than 30% of taxable income or a similar measure.
- The Proposed Regulations introduce an example concluding that a foreign tax does not fail the cost recovery requirement even though the underlying foreign tax law disallows deductions for stock-based compensation.
- A new prong to the source-based attribution requirement for royalties would allow a taxpayer to satisfy the requirement if it has a licensing agreement expressly limiting use of intangible property to the country imposing the tax (the single-country rule). The single-country rule would further permit a licensing agreement to bifurcate a license payment between payment for use within versus outside the country imposing the tax. Taxpayers would not satisfy the single-country rule if they know, or have reason to know, that the licensing agreement misstates the territory in which the intangible property is used or overstates the royalties otherwise eligible for the single-country rule. The Proposed Regulations would require the licensing agreement to be executed no later than the date of the royalty; an exception exists for certain agreements executed no later than 17 May 2023.
- The Proposed Regulations would revise the rules on disregarded reallocation transactions under Reg. Section 1.861-20 by providing that disregarded payments received in exchange for property do not constitute reattribution assets for purposes of allocating and apportioning taxes upon a disregarded remittance.
- The rules on the cost recovery and attribution requirements would apply to foreign taxes paid in tax years ending on or after 18 November 2022. In contrast, the rules on disregarded payments would apply to tax years ending on or after the date that final regulations are filed with the Federal Register. In both cases, taxpayers may choose to apply the rules contained in the Proposed Regulations to earlier tax years if they do so consistently. Taxpayers may also rely on the Proposed Regulations before their finalization, subject to certain requirements.
A senior Internal Revenue Service (IRS) official said this week that proposed regulations under Section 367(d) will be released early next year, rather than by year-end. The regulations will limit a royalty inclusion for intellectual property that left the US and was subsequently repatriated. Earlier this fall, a government official said the proposed regulations "would provide high-level situations where you could turn off that royalty after [the IP] has been repatriated.” The official indicated that the upcoming Section 367(d) proposed regulations are separate and apart from a project on the 2023 priority guidance plan that would address changes to Section 367(d) and Section 482 regarding aggregation and the definition of intangible property
The acting commissioner of the IRS Large Business and International Division this week said the IRS is considering using the economic substance doctrine in transfer pricing audits, even where the taxpayer has transfer pricing documentation. “We are thinking about economic substance, of sham transactions, and also assertion of penalties” in transfer pricing cases, according to the official. The IRS also reportedly plans to increase its transfer pricing staff.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transaction Services, Washington, DC
- Arlene Fitzpatrick
- Joshua Ruland
