IRS announces extension in the transition period for foreign withholding tax rules

The Internal Revenue Service (IRS) and the Treasury Department of the United States recently announced that they plan to extend the transition period for the exception rule obliging companies to pay taxes on royalties of intellectual property abroad.

Pursuant to Notice 2023-31, issued on April 3, 2023, following the finalization of regulations proposed in Section 903 of the Tax Code (REG-112096-22), the Treasury Department and the IRS wish to extend the transition period from May 17, 2023 to 180 days after the date the final regulations (which adopt single country exception documentation) are filed with the Federal Register.

According to federal agencies, the single country exception leaves a company exempt from the source-based attribution requirement for foreign withholding taxes on royalties paid for the use of intellectual property within the withholding jurisdiction under Section 903.

The proposed regulation makes reference to the following points:

  • Foreign tax credit;
  • Guidance on the asset return rule for foreign tax allocation and division purposes;
  • Mandatory cost recovery;
  • Withholding tax assignment rule on royalty payments.

According to the notice, “a foreign tax is a credible net income tax only if the determination of the foreign tax base complies, in essential respects, with the determination of taxable income under the code. To meet this test, a foreign tax must satisfy the net income requirement, which comprises the realization requirement, the gross earnings requirement, the cost recovery requirement (formerly the net income requirement), and the attribution requirement.”

Within the assignment requisite, the requirement is that a foreign tax complies with the tax jurisdiction concepts contained in the Tax Code. Foreign source taxes – including activity-based attribution, source-based attribution or property-based attribution tests – that are intended for non-resident taxpayers have the scope of revenues and gross costs limited by the attribution requirement.

Under the source-based rule, a foreign tax levied on a non-resident’s income falls under the attribution requirement only if the source rules of the foreign tax law resemble the source rules applicable for federal income tax purposes. For gross revenues generated from royalties, foreign tax law must obtain royalties based on the place of use or right to use the intangible property.

Under the Tax Code, foreign withholding taxes must meet source-based assignment requirements to qualify as a “covered withholding tax” and thus can be credited as a tax rather than an income tax. That is, a withholding tax on a royalty payment will only be creditable if foreign tax law gives rise to royalties based on place of use or the right to use the intangible property.

See the IRS release for more information: https://www.irs.gov/pub/irs-drop/n-23-31.pdf

Written by Aline Ribeiro, Senior Communications Consultant

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