On December 11, 2023, the Internal Revenue Service (“IRS”) released Notice 2023-80 (the “Notice”) establishing the intentions of the Treasury Department (“Treasury”) and the IRS to issue proposed regulations addressing the application of the foreign tax credit (“FTC”) rules and dual consolidated loss (“DCL”) rules with respect to certain taxes under the Pillar Two global anti-base erosion (“GloBE”) rules.
The Notice also extends the temporary relief from the 2022 FTC final regulations that was offered by Notice 2023-55, which allowed taxpayers to rely on the pre-existing FTC rules, provided that taxpayers did so consistently. Notice 2023-80 extends the relief period until further guidance described in the Notice is issued, with the applicable period now ending before the date that a notice or other guidance withdrawing or modifying the temporary relief is issued.
Overview of Pillar Two
Pillar Two, which focuses on global minimum taxation, aims to ensure that multinational enterprise groups (“MNE Group”) with over EUR 750 million of annual revenue are subject to a minimum tax of at least 15 percent in each jurisdiction in which they operate. Under the GloBE rules, an in-scope MNE Group must calculate its effective tax rate (“ETR”) for each jurisdiction in which it operates. If the ETR for a jurisdiction is below 15 percent, a top-up tax may be imposed and collected under Pillar Two’s income inclusion rule (“IIR”), qualified domestic minimum top-up tax (“QDMTT”), and undertaxed profits rule (“UTPR”).
A QDMTT is a minimum tax included in the domestic law of a jurisdiction, allowing the source jurisdiction to maintain its primary authority over profit taxation in order to ensure an ETR of at least 15 percent. The QDMTT raises the domestic tax burden to an ETR of at least 15 percent on the domestic excess earnings by calculating the excess (and undertaxed) profits of constituent entities situated in a jurisdiction. In order to qualify as a QDMTT, such regime must exclude taxes paid or accrued by domestic constituent entities with respect to the income of foreign constituent entities that are subject to the controlled foreign corporation (“CFC”) regime pertaining to its jurisdiction.
The IIR operates similarly to the CFC rules in the US. When the ETR for a jurisdiction is less than 15 percent after accounting for the QDMTT and CFC tax regimes, the IIR is applied to the ultimate parent entity or intermediary parent entity in proportion to its ownership interests in any constituent entities that have excess profit taxed at an ETR lower than 15 percent.
Lastly, the UTPR acts as a backstop to these provisions. In the event that the QDMTT and IIR fail to attain a minimum 15 percent ETR on profits within a given jurisdiction, the UTPR permits jurisdictions that are beyond the ultimate parent entity’s jurisdiction to levy taxes in order to meet the minimum ETR threshold.
FTC Guidance under the Notice
Section 2 of the Notice sets forth that certain kinds of foreign taxes imposed under the GloBE rules will generally be eligible for the FTC; however, the IRS notes that much will depend on the types of taxes and the persons involved.
Generally, no FTC or deduction is allowed under sections 901 or 59(l) to a person for a final top-up tax if any US federal income tax liability of the person would be taken into account in computing the “final top-up tax”.
“Final top-up tax” is a new concept introduced in the Notice. The Notice defines a final top-up tax as any foreign income tax (“tested tax”), which takes into account either: (i) the amount of tax imposed on the direct or indirect owners of the entity subject to the tested tax by other countries (including the US) with respect to the income subject to the tested tax, or (ii) in the case of an entity subject to the tested tax on income attributable to its branch in the foreign country imposing the tested tax, the amount of tax imposed on the entity by its country of residence with respect to such income.
The final top-up tax concept seems to have been developed in order to circumvent the circularity that taxpayers would face when figuring out their FTCs under the GloBe rules and US federal income tax law. But with the implementation of this rule, taxes levied as IIRs will be essentially non-creditable for US federal income tax purposes. Although the Notice does not provide guidance with respect to the credibility of a tax imposed as a UTPR, it is anticipated that these types of taxes will also not be creditable.
With respect to CFCs and partnerships, although a final top-up tax imposed is not creditable under section 901 at the shareholder or partner level, such top-up tax will be treated as if it were a creditable tax at the CFC or the partnership level and will be included in the section 78 gross-up. However, neither the high-tax exclusion under section 954(b)(4) nor the GILTI high-tax exception under section 951A may be taken into account when calculating a final top-up tax. Consequently, US taxpayers will find it more challenging to choose the high-tax exemptions to subpart F and GILTI for CFCs that would otherwise be subject to a high tax rate under Pillar Two as a result of final top-up taxes.
Treasury and the IRS intend to amend the non-duplication requirement of Treasury Regulation section 1.903-1(c)(1)(ii). The proposed amendment would clarify that the IIR, UTPR, and QDMTT do not violate the non-duplication requirement.
Lastly, the Notice provides several examples on the application of these rules, including as it pertains to IIR that is a foreign income tax, Minority US shareholder, and QDMTT that is a foreign income tax.
The Notice also provides guidance that is intended to be consistent with forthcoming proposed regulations, which describes how the separate levy rules of Treasury Regulation section 1.901-2(d) apply with respect to an IIR, UTPR, and QDMTT. In essence, each of an IIR, UTPR, and QDMTT imposed by a foreign country is a separate levy within the meaning of Treasury Regulation section 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).
QDMTT allocation keys
The Notice also provides guidance on which person is eligible to claim the FTC when a QDMTT imposed by a foreign jurisdiction is considered paid by, or computed by reference to the income of, two or more persons.
In cases where a QDMTT is imposed by a foreign jurisdiction on the combined income of two or more persons, the Notice sets forth a new allocation mechanism in which foreign tax law is considered to impose the legal liability for the QDMTT on each person in proportion to the person’s “QDMTT allocation key,” rather than the current standard set forth in Treasury Regulation section 1.901-2(f)(3).
A persons QDMTT allocation key is generally the product of (i) the excess (if any) of the minimum ETR of the foreign jurisdiction over the taxes paid by the person that are taken into account to compute the QDMTT, and (ii) the person’s total income (or loss) that is taken into account under the tax laws of the jurisdiction for determining the QDMTT. If a person’s separate QDMTT income is zero or less than zero, meaning the entity either had no income or had a loss, such person’s QDMTT allocation key is deemed to be zero. This means that if foreign tax law calculates the QDMTT of two separate, but mutually owned, CFCs and one CFC recognizes a loss or has zero income, such CFC cannot claim any portion of the QDMTT assessed against the group under foreign tax law for the purposes of calculating their FTC.
The Notice provides several examples on the application of these rules to a QDMTT imposed on two or more persons as well as other applications.
Primer on DCLs
The DCL provisions under section 1503(d) and the regulations thereunder prevent “double dipping” of losses, which occurs when the net operating loss of a dual resident corporation or the net loss attributable to a separate unit offsets both income subject to US tax (but not a foreign jurisdiction’s tax) and income subject to the foreign jurisdiction’s tax (but not US tax). Under the DCL rules, the DCL of a corporation may not reduce the taxable income of any other member of the affiliated group for that tax year or any other tax year. Moreover, this rule is applied to a dual consolidated loss of a separate unit of a domestic corporation as if the separate unit were a wholly-owned subsidiary of that corporation.
Nonetheless, a domestic use of a DCL is permitted if the taxpayer makes a domestic use election, which requires the taxpayer to certify that there has not been, and will not be, a foreign use of the DCL. Under this domestic use election, a taxpayer effectively has the choice to put a DCL to a domestic use or a foreign use (but not both).
DCL Guidance under the Notice
The Pillar Two GloBE rules use a jurisdictional blending approach under which all income and loss of constituent entities in the same jurisdiction are generally aggregated to determine whether an MNE Group is below the minimum 15 percent ETR. Additionally, the GloBE rules do not permit a mechanism to opt-out of aggregation; therefore, a taxpayer might effectively be required to put a DCL to a foreign use rather than having the potential choice between a domestic use and a foreign use. Some view this aggregation as giving rise to the same double dipping concerns that the DCL rules were intended to address. For example, if a loss that gives rise to a DCL is aggregated with other items that are, under US federal income tax principles, items of the foreign corporation in that jurisdiction for purposes of determining net GloBE income, the loss would be available to reduce both US tax (if a domestic use election were permitted) and the jurisdictional top-up tax.
Among other IRS concerns detailed in the Notice, the Notice points out that a loss may never produce a benefit under the jurisdictional top-up tax in such cases when the ETR in the jurisdiction is at or above the minimum ETR and the loss is not carried over in determining jurisdictional top-up tax in another year.
The Notice states that the Treasury and the IRS are studying the extent to which DCL rules should apply with respect to the GloBE rules, including the extent to which such aggregation results in a foreign use of the DCL and whether such rules would cause an entity that is not otherwise subject to an income tax of a foreign jurisdiction to be a dual resident corporation or a hybrid entity.
The Notice states that the Treasury and the IRS intend to issue proposed regulations regarding “legacy DCLs” such as DCLs incurred (i) in taxable years ending on or before December 31, 2023, or, (ii) in taxable years beginning before January 1, 2024 and ending after December 31, 2023; provided, the taxpayer’s US taxable year begins and ends on the same dates as the fiscal tax year of the MNE Group under the GloBE rules.
Under the forthcoming proposed regulations, a legacy DCL will not be foreign use solely because a portion or all of the deductions or losses that comprise the legacy DCL are taken into account in determining the net GloBE income for a particular jurisdiction. Thus, it seems that the rules proposed under the Notice would prevent the GloBE rules from triggering an event causing a DCL in cases where DCLs are already subject to an existing domestic use election or otherwise eligible to make a domestic use election for DCLs incurred in 2023. Taxpayers may rely on this rule until the forthcoming proposed regulations are published; however, the rule will not apply to any DCL that was incurred or increased with the intention of reducing the jurisdictional top-up tax or qualifying for the proposed rule under the Notice.
Lastly, the Notice solicits comments on this topic and sets forth detailed procedures for submitting such comments.