IRS’s Pillar Two, Foreign Tax Credit Guidance Present Conflicts

The Treasury Department and IRS on Dec. 11 released Notice 2023-80, describing forthcoming proposed regulations on the interaction of the US tax system with Pillar Two.

It addresses the extent US taxpayers will be entitled to a foreign tax credit for certain Pillar Two top-up taxes and whether Pillar Two would trigger the recapture of “legacy” dual consolidated losses.

In addition, the notice indefinitely extends Notice 2023-55, which allowed taxpayers relief from application of controversial January 2022 modifications to longstanding foreign tax credit regulations.

While the guidance provides clarity on key issues, the notice refrains from articulating the policy rationale or technical basis for the proposed rules.

Under existing law, it isn’t clear that Pillar Two taxes can (or should) be excluded from the US exceptions for high-taxed income. Nor is it clear how a Pillar Two tax could be ineligible for the US foreign tax credit but nevertheless result in a deemed dividend inclusion.

Hopefully, the ongoing rulemaking process will resolve these tensions.

US Foreign Tax Credits

On Jan. 1, top-up taxes pursuant to the OECD’s Pillar Two work will come into effect in more than two-dozen countries. These taxes include qualified domestic minimum top-up taxes and income inclusion rules consistent with the Pillar Two GloBE model rules.

Under the notice, creditability for each US taxpayer would hinge on whether the foreign tax is a final top-up tax that takes into account any amount of that taxpayer’s US tax liability. A QDMTT that conforms to the GloBE model rules wouldn’t be considered a final top-up tax, and a US shareholder would generally be allowed a foreign tax credit.

In contrast, an IIR tax would be considered a final top-up tax for which a foreign tax credit would be prohibited in many cases. The notice doesn’t provide guidance on undertaxed profits rules, which aren’t expected to come online until 2025 at the earliest.

Whether a US foreign tax credit is permitted for an IIR tax would depend on whether the tax is computed by accounting for US taxes imposed on the direct and indirect owners of the tested company, with such taxes allocated to the tested company when calculating its effective tax rate.

Under the GloBE model rules, shareholder taxes are only pushed down to the tested company to compute the IIR tax if the shareholder and the tested company are part of the same MNE group.

Consequently, a controlling US parent company would be unable to credit an IIR tax, while a minority US corporate shareholder or an individual US shareholder may be permitted a credit.

Taxing Jurisdiction Tug-of-War

The proposed approach follows the Pillar Two ordering rules, which prioritize controlled foreign corporation taxes imposed by an ultimate parent entity before any IIR tax imposed by an intermediate parent entity.

For US parented multinationals, if the US afforded a foreign tax credit for the IIR tax, it would trigger recursive calculations that result in the US ceding most of its claim to tax the excess profits of CFCs.

Allowing a credit for the IIR tax would reduce CFC taxes imposed at the US parent level. This would reduce CFC taxes allocated to tested companies when calculating their effective tax rates, which would increase the IIR tax imposed by intermediate parent companies, thereby increasing the amount of IIR tax eligible for the US foreign tax credit.

Upon reaching equilibrium, the country of the intermediate parent entity would capture most of the taxing jurisdiction.

The notice excludes final top-up taxes from the computation of the Subpart F and GILTI high-tax exceptions. This rule appears to avoid a similar dynamic in which counting an IIR tax imposed on the intermediate parent company could result in the US applying the high-tax exception and effectively ceding the right to tax excess profits of lower-tier companies.

This result isn’t required by the Pillar Two ordering rules and arguably conflicts with the policy of excluding income from the scope of Subpart F and GILTI, where the income hasn’t been shifted abroad to reduce US tax.

Basis for Credit Denial

The political agreement the Treasury Department negotiated at the Organization for Economic Cooperation and Development regarding CFC taxes hasn’t been incorporated into domestic law. While the notice provides welcome confirmation of the expected approach in future regulations, it doesn’t articulate the technical basis under the federal tax code.

The notice provides that an IIR tax may be a foreign income tax for purposes of the foreign tax credit rules and states that such tax is “treated as if it were a creditable tax at the partnership and CFC level,” with any disallowance applying at the level of the partner or US shareholder.

The credit would then be disallowed if the IIR tax was computed by taking into account the US taxes imposed with respect to the income of the tested company. Otherwise, the amount of the IIR tax imposed would increase to the extent the US afforded a credit.

This mechanism for disallowing the credit is consistent with treating IIR taxes as a novel form of soak-up tax, as proposed by the New York State Bar Association. However, unlike a traditional soak-up tax, the Pillar Two rules are designed to impose a 15% minimum tax, regardless of whether a US foreign tax credit is available.

Given the complex interaction of the rules involved, it seems possible that double taxation could result from a failure to provide a foreign tax credit for IIR taxes in certain cases.

Potential Rules Conflict

Under Reg. Section 1.901-2(e)(6), a foreign tax credit is denied for soak-up taxes by treating the tax as “not an amount of foreign income tax paid.” However, the notice says the US parent company is deemed to pay the IIR tax and requires the company to include it as a dividend under Section 78 of the tax code, again as foreign income tax deemed paid.

While this rule may also be designed to prioritize US CFC taxes, if the technical basis for denying the credit is that it constitutes a form of soak-up tax, then the IIR tax shouldn’t be considered a deemed paid foreign tax for which an inclusion under Section 78 is required.

Section 78 ensures that a foreign tax is credited against an appropriate amount of pre-tax income. Where no credit is permitted, Congress has often (but not always) provided that the Section 78 gross-up isn’t required.

When this notice is converted into proposed regulations, the rulemaking should explain how the rules denying a foreign tax credit are internally consistent with the rules requiring a Section 78 deemed dividend.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jeffrey Tebbs is member and Caroline Reaves is counsel in the tax practice at Miller & Chevalier Chartered.