Background
In November 2022, Treasury and the IRS published proposed regulations (the “Proposed Regulations”) that provide a limited exception to the source-based attribution requirement for withholding taxes on certain royalty payments.1 The exception requires a written license agreement that characterizes the payment as a royalty and that either limits the territory of use of the IP to the country imposing the withholding tax or separately—and accurately—states the portion of the royalty that is attributable to the use of the IP in the country imposing the withholding tax.2 For a detailed discussion of the Proposed Regulations and the single-country license exception, please see our prior client alert, FTC Regulations Get a Proposed Makeover.
The additional time afforded by the Notice should generally be welcome news, particularly for taxpayers that are dealing with unrelated third parties, for which the 17 May deadline was proving to be quite challenging. However, as discussed more fully below, taxpayers must decide whether to execute or amend agreements in reliance on the Proposed Regulations (as permitted by the preamble to the Proposed Regulations) or, now that they have more time, wait until Treasury and the IRS publish the final regulations, possibly with more restrictive or different requirements to qualify for the single-country license exception.
While taxpayers and practitioners were generally receptive to the single-country license exception, they raised several concerns with various of the requirements to qualify for the exception. For example, several commenters recommended that the single-country license exception should not require the use of particular words (e.g., “royalties”) in the tested agreement.3 Rather, commenters recommended that the single-country license rules should simply defer to the foreign tax law characterization of a payment, consistent with the general source-based attribution requirement in Treas. Reg. § 1.901-2(b)(5)(i)(B)4, without regard to how the taxpayer’s agreement “characterizes” (or otherwise labels) the payment. Most relevantly for purposes of the Notice, some commenters also requested that Treasury and the IRS issue a notice as soon as possible to extend the 17 May 2023 deadline to a date that is one year after the issuance of final regulations. Taxpayers were understandably concerned that they may not be able to negotiate and implement the required changes to their agreements, particularly with third parties, by the 17 May 2023 deadline. Taxpayers’ concerns were well-founded, as many third parties based in other countries are not familiar with US tax rules, let alone the intricacies of the single-country license exception.
Therefore, the Notice provides that, “to allow for an orderly implementation of the requirements of the single-country exception, including for relevant periods before the finalization of the single-country exception, the Treasury Department and the IRS intend to modify the transition documentation rule when the single-country exception in proposed § 1.903-1(c)(2)(iii)(B) is finalized to provide that the required agreement must be executed no later than 180 days after the date final regulations adopting the single-country exception are filed with the Federal Register.” Consistent with the reliance language found in the preamble to the Proposed Regulations, the Notice also provides that taxpayers may rely on the extended deadline provided under the Notice for foreign taxes paid in taxable years beginning on or after 28 December 2021, and ending before the effective date of final regulations adopting the single-country exception, provided that the foreign tax is otherwise eligible for the single-country exception under the Proposed Regulations.
Execute now or wait until after publication of the final regulations?
The Proposed Regulations are proposed to generally apply to foreign taxes paid in taxable years ending on or after 22 November 2022.5 However, according to the preamble to the Proposed Regulations, taxpayers may choose to rely on the provisions addressing the single-country license exception for foreign taxes paid in taxable years beginning on or after 28 December 2021 (i.e., the effective date for the source-based attribution requirement), and ending before the effective date of final regulations adopting these rules.
It is possible that the final regulations may include additional, possibly more restrictive, requirements to qualify for the single-country license exception. For example, a government official was recently reported as saying that “both [the United States and the foreign country imposing the withholding tax] would have to characterize the transaction [in that case, a software-as-a-service agreement] as a license subject to royalties due to the fundamental interests against crediting digital services taxes.”6 Our reading of the Proposed Regulations is that the single-country license exception does not appear to require that the US tax law characterization of a payment match the foreign tax law characterization or the characterization of the payment under the relevant agreement.7 Nevertheless, it is possible that Treasury and the IRS may attempt to include a matching requirement in the final regulations, although the validity of regulations including any new requirement for the first time in the final regulations may be subject to challenge under the Administrative Procedure Act. The final regulations may also provide more prescriptive rules for purposes of determining whether licensed intangible property is used (exclusively or in part) in the country imposing the withholding tax.
In light of the above, taxpayers should assess whether to execute new agreements (or amend existing agreements) in reliance on the Proposed Regulations or wait to execute or amend such agreements until after the final regulations are published. For taxpayers that intend to execute agreements in reliance on the Proposed Regulations, there remains the question of whether Treasury and the IRS will provide any transition relief for agreements executed before the effective date of the final regulations. For example, assume that the Proposed Regulations are finalized on, say, 1 November 2023. According to the Notice, Taxpayers would have until 29 April 2024, to execute or amend agreements to comply with the single-country license exception as set forth in such final regulations. Further assume that a calendar year taxpayer, in reliance on the Proposed Regulations, executed amendments to its relevant agreements, effective on 1 May 2023, to comply with the Proposed Regulations. The single-country license exception would therefore generally apply to any royalties paid before 1 May 2023.8 If the final regulations include provisions that tighten the availability of the single-country license exception, such that the agreement as executed would qualify for the single-country license exception pursuant to the Proposed Regulations, but not pursuant to the final regulations, it would appear that the taxpayer in the example above may rely on the Proposed Regulations for its 2022 taxable year, but not for its 2023 taxable year because the 2022 taxable year is the last taxable year ending before the effective date of the final regulations. To the extent there are changes to the requirements between the Proposed Regulations and the final regulations, it would be useful for Treasury and the IRS to provide transition rules in the final regulations for taxpayers in such a position, who reasonably relied on the Proposed Regulations. Such transition rules may provide, for example, that taxpayers may continue to rely on the Proposed Regulations for the remaining term of any agreement executed pursuant to the Proposed Regulations before the effective date of the final regulations. If taxpayers instead are required to re-execute or re-amend their agreements, we would hope that any transition rules would provide that the final regulations would not impact taxpayers’ earlier reasonable reliance on the Proposed Regulations.
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2 Prop. Treas. Reg. § 1.903-2(c)(2)(iv).
3 An IRS official has recently publicly stated that the Proposed Regulations do not require the use of particular “magical” words in the tested license agreement. See IRS Official Signals Flexibility for Foreign Tax Credit Exception, Natalie Olivo, Law360 Tax Authority (March 23, 2023). In this regard, the Proposed Regulations require that “the terms of the license agreement pursuant to which the payment is made characterize the payment as a royalty.” Prop. Treas. Reg. § 1.903-2(c)(2)(iv)(A).
4 See also Prop. Treas. Reg. § 1.903-1(c)(2)(iii)(B) (second sentence).
5 Prop. Treas. Reg. § 1.903-1(e)(3).
6 Official Defends Policy Behind Foreign Tax Credit Rules, Natalie Olivo, Law360 Tax Authority (Jan. 25, 2023).
7 Prop. Treas. Reg. § 1.903-1(c)(2)(iii)(B) (second sentence) (“whether the income is characterized as royalty income is determined under the foreign tax law, except [for copyrighted articles].” There are often disputes between taxpayers and foreign tax authorities regarding the proper characterization of certain payments (e.g., certain transactions involving software-as-a-service) as services or royalties.
8 Prop. Treas. Reg. § 1.903-2(c)(2)(iv)(D).
