Foreign Tax Credit Regulations: Recent Updates for Taxpayers with Royalty Income from Abroad

If you are an American taxpayer who earns income from abroad, you may already be familiar with the foreign tax credit (FTC). In short, taxpayers who pay taxes to foreign countries for income earned abroad may be able to offset a portion of their tax liability in the US using the FTC. For companies and individuals with royalty and licensing agreements that allowed foreign entities to use their “intangible property,” this was often a valuable credit that enabled them to avoid paying taxes twice on the same income.

In 2022, changes to the regulations made many royalty withholding taxes non-creditable. However, more recent clarification has allowed taxpayers to continue claiming the FTC under certain circumstances. Taxpayers with foreign-earned royalty income will want to know about the most recent changes so that they can evaluate their current situations and ensure they are making the most of all available tax credits.

Background
Established in 1994, Internal Revenue Code Sections 901 and 903 allow American taxpayers to claim taxes paid on foreign-earned income to foreign countries to claim those taxes as a credit against their regular US tax liability. However, the 2022 FTC regulations made changes that meant that many royalty withholding taxes would become non-creditable.

In January 2022, the IRS released a clarification that US taxpayers could claim credits for withholding taxes on royalty payments if their royalty agreement includes language that specifically identifies the intangible property as being used in the country where the tax is being withheld. This requirement is known as the single-country use exception.

In November 2022, the IRS released proposed regulations that provided additional guidance about the FTC on issues such as such as cost recovery and attribution requirements for royalty payments. Going forward, not every tax paid in a foreign country will qualify for the foreign tax credit. Under the new FTC rules, the tax the FTC is being taken on must be a similar to a tax imposed in the United States.

Single-country use exception
The single-country use exception allows the taxpayer to potentially credit a portion of these withholding taxes. (When utilized, the foreign tax credit is not a dollar-for-dollar reduction on the US tax, but it does credit a substantial portion of the foreign tax.) A single country exception applies if:

1. The income subject to the foreign tax is characterized as royalty income under a particular country’s tax law; and
2. The payment giving rise to such income is made subject under a single country license

In other words, the license agreement that a US taxpayer has with a foreign entity for royalty payments must specifically identify the intangible property as being used in the country where the tax is being withheld.

180-day timeline
Initially, the deadline for taxpayers to amend their royalty agreements to qualify for the single-country use exception was May 17, 2023. However, on April 3, 2023, the IRS released Notice 2023-31, which included guidance extending the transition period. Taxpayers now have 180 days from the date that the November 2022 regulations are finalized to update their royalty agreements to qualify for the single-country use exception.

The IRS is still considering comments from taxpayers and accounting professionals and has not announced when that finalization will happen.

Double-tax treaty
But wait, there’s more! Whether you get a credit, and how much credit you get, will depend on whether your income is coming from a country that has an income tax treaty with the United States. The IRS has a complete list of these countries here.

If your royalties are coming from a country without such a treaty, you will need to pay tax both in that country and in the US.

What This Means for Taxpayers with Foreign-Earned Royalties
While the additional six months is welcome, individuals and business owners with royalty income from outside the United States should begin the process of reviewing and evaluating their agreements as soon as possible.

If you are a taxpayer in this situation, we strongly recommend working with a Tonneson tax advisor to fully understand all your options and obligations. Modifying existing royalty agreements can help preserve foreign tax credits, but the potential impact of commercial and transfer price considerations should also be considered. Our advisors can help you choose the best course of action for your specific situation.

Contact us at Tonneson + Co today to learn how we can help.