cite foreign tax credit presentation by randy free january 2011

© Grant Thornton LLP. All rights reserved.

CITE: US International Tax Reporting & Compliance - 2011

Computing Direct and Indirect Foreign Tax Credit Benefits

January 24, 2011

Randy FreePartner - International Tax Services Grant Thornton, LLPIrvine, CaliforniaTelephone: (949) [email protected]


Circular 230 Disclosure

To ensure compliance with requirements imposed bythe IRS, any U.S. federal tax advice contained in thisdocument is not intended or written to be used, andcannot be used, for the purpose of (i) avoidingpenalties under the Internal Revenue Code or (ii)promoting, marketing, or recommending to anotherparty any transaction or matter that is contained inthis document.

© Grant Thornton LLP. All rights reserved. 3

Learning objectives

• Recognize the importance of foreign tax credit

• Be aware of the key concepts regarding

foreign tax credit

Disclaimer: This presentation provides a high-level overview of the general rules relating to foreign tax credits. It should be noted that there

are several special rules and exceptions in the Code and regulations that may apply and need to be considered that are not discussed.


Agenda

• Introduction• Source of income rules• Credit limitations• Indirect credit• Changes to FTC


Introduction Foreign Tax Credit

• The U.S. taxes its citizens, residents and domestic corporations on a world-wide basis, which can result in double taxation when the U.S. person is also taxed by another country

• Generally, IRC § 901 allows: – Credit for foreign taxes paid or deemed paid by

qualifying taxpayers – Taxpayers must elect the credit in lieu of deducting the

taxes• The foreign tax credit is meant to minimize double taxation


U.S. Tax Return Foreign Country Tax Return

Foreign source income $1,000 Income $1,000

Taxable income $1,000 Taxable income $1,000 x .35 x .25

U.S. income tax $ 350 Foreign income tax $ 250

U.S. tax $350Foreign tax $250Worldwide tax $600

Worldwide ETR 60.00% [$600/$1,000]

U.S. taxation without FTC


U.S. Tax Return Foreign Country Tax Return

Foreign source income $1,000 Foreign source income $1,000

Taxable income $1,000 Taxable income $1,000 x .35 x .25

U.S. income tax $ 350 Foreign income tax $ 250Less FTC < 250>U.S. tax after FTC $ 100

U.S. tax $100Foreign tax $250Worldwide tax $350

Worldwide ETR 35% [$350/$1,000]

U.S. taxation with FTC


Double tax minimization

FTC does not eliminate double taxation in all cases because • Not all U.S. taxes are available to be reduced by the credit• Not all U.S. taxpayers qualify• Not all foreign taxes are creditable• FTC limitation restricts creditability• Source of income rules differ between countries• Allocation and apportionment rules differ between countries


Taxes against which credit allowed

Generally, allowed against tax imposed by I.R.C. §§ 1 and 11• Individual income tax• Estate income tax• Trust income tax• Corporate income tax• Nonresident alien income tax on effectively connected

income• Foreign corporate income tax on effectively connected

income


Taxes against which credit is NOT allowed

• Credit not available to non-resident alien or foreign corporation against withholding taxes (IRC §§ 871(a) & 881)

• Credit not available to foreign corporation against branch profits tax (IRC §§ 26(b)(2)(K) & (N))

• Penalty tax on retirement plan distribution• Accumulated earnings tax• Personal holding company tax• Sub S – BIG tax


Taxpayers qualifying for credit

• U.S. citizens• Domestic corporations• Bona fide residents of Puerto Rico• Foreign corporations with effectively connected income• Nonresident aliens with effectively connected income• U.S. resident aliens from countries granting reciprocal

credits• Partners of partnerships• Beneficiaries of trusts and estates


Creditable foreign taxes

Creditable foreign taxes include• Income tax imposed by a foreign country or a U.S.

possession IRC § 901(b)• The predominant character must be that of an income tax

1. Compulsory levy; and2. Not a payment for a specific benefit to taxpayer

• Foreign income taxes imposed by political subdivisions• Foreign taxes imposed "in lieu of" an income tax IRC §

903(a)

Penalties, fines, interest and customs duties are not taxes


Non-creditable foreign income taxes

Generally, non-creditable foreign income taxes include• Tax paid to listed countries IRC § 901(j)

– Denies credit to countries with which the U.S. has bad relations

1. U.S. does not recognize its government;

2. U.S. does not have diplomatic relations with the country; or

3. The country is designated as supporting acts of terrorism• Withholding tax on short-term holders of stock (IRC § 901(k)(1)(A))

– Denies credit for withholding tax unless length of ownership test is met

• Antiabuse rules– May deny credit for tax paid in certain tax-motivated transactions


Credit limitation - generally

• Under IRC § 904(a) the credit for foreign income tax may not exceed the U.S. tax on foreign sourced income– Prevents the FTC from being taken against U.S. tax on

U.S. income

• Taxpayer's worldwide tax liability on foreign source income equals the greater of– Pre-credit U.S. tax on the income; or– Foreign income tax


Overall limitation

• Allowed FTC is the lesser of1. Creditable Foreign Income Taxes, or2. FTC Limitation

• Taxes exceeding the limitation can be carried back to the 1st preceding tax year and then forward through the tenth year following the taxable year

• The FTC limitation is determined using the source rules of IRC §§ 861 and 862

Foreign Tax Credit Limit

Foreign Source Taxable Income

World Wide Taxable Income

U.S. Tax Before FTCx=


U.S. Tax Return Foreign Tax Return

U.S. Foreign Total

Taxable Income 1,000 1,000 2,000 1,000

Tax Rate 35% 45%

Income Tax 700 450

Less: FTC -350

Tax After FTC 350

Foreign Tax Credit Limitation

= 1000/2000 * 700 = 350

Credit limitation - generally


Agenda

• Introduction• Source of income rules • Credit limitations• Indirect credit• Changes to FTC


Source of income rules

Income Type Source Rule Reference

Dividends Residence of payor; unless, foreign company earns 25% or more ECI over 3-year period

IRC § 861(a)(2)IRC § 862(a)(2)

Interest Residence of obligor; unless, domestic obligor (so called “80-20 company” earns 80% or more of gross income from foreign sources over three year period (or year of payment if no gross income for such 3-year period))

IRC § 861(a)(1)IRC § 862(a)(1)

Rents and Royalties

Location of tangible property; place of exploitation of intangible property

IRC § 861(a)(4)IRC § 862(a)(4)




Management Fees Place where services are performed IRC § 861(a)(3)IRC § 862(a)(3)

Gains from Personal Property Sales (e.g., Capital Gains)

Residence of seller IRC § 865(a)

Gain on Sale of Foreign Affiliate Stock

Foreign source if sale occurs in the foreign country and at least 50% of affiliate’s income over past three years is derived from active business in its country

IRC § 865(f)

Gain on Sale of Intangibles

Residence of seller; unless, contingent on productivity or use of the intangible (if so, source rule for royalty controls); Foreign source if treaty applies

IRC §§ 865(d) and (h)




Gain on Sale of Purchased Inventory Property

Place of sale (Exception applies to purchases in U.S. possessions) See Treas. Reg. §1.863-3(f))

IRC § 861(a)(6)IRC § 862(a)(6)

Gain on Sale of Produced Inventory Property

Generally 50/50 between production and sales activities

IRC §863(b)

Interest, Dividends and Subpart F Inclusions from controlled foreign corporations

Look-thru rule - Foreign if so prescribed under normal rules for interest and dividend income; unless, attributable to payor’s income from U.S. sources

IRC § 904(g)


FTC limitation – old separate basket rules

1. Passive Income (i.e. interest, rents, royalties, etc.)

2. High Withholding Tax Interest (i.e. subject to withholding tax ≥ 5%)

3. Financial Services Income

4. Shipping Income

5. Certain dividends received from non-controlled section 902 foreign corporations (10/50 corporations) (eliminated post 2002, look-thru applies AJCA 2004)

6. Certain DISC dividends

7. Taxable income related to certain foreign trade income

8. Certain FSC dividends

9. All other income (i.e., the general limitation)


FTC limitation – new separate basket rules

Effective for tax years beginning after December 31, 2006, the number of foreign tax credit limitation categories or baskets has been reduced to two: passive income and general category income IRC § 904(d)(1)


Impact of separate basket

• Baskets limit the ability to “cross credit” foreign taxes on high-taxed foreign source income against U.S. tax on low-taxed foreign source income

• Planning Idea: get low-taxed income into the general limitation basket and/or high-taxed income into the passive basket


Separate basket limitation

Foreign Tax Credit Limit

Foreign Source Taxable Income Within Basket

World Wide Taxable Income

U.S. Tax Before FTCx=


Example: Foreign Tax Credit

• Facts– Assume a U.S. corp earns $100,000 in total taxable

income (U.S. 1120)– Of this total, $50,000 is foreign source taxable income– U.S. corp pays $20,000 of foreign taxes (direct and

indirect)

• Consider the effect of the foreign source income being classified into two separate baskets versus a single basket


--Foreign Source-- US 1120 ---US Source--- General Limitation

Taxable Income $100,000 50,000 50,000 U.S. Tax Liability Before FTCs $34,000

Potential Foreign Tax Credits: Sec. 901 Direct Credits 5,000 Sec. 902 Deemed Paid FTCs 15,000 Total Potential FTCs 20,000

FTC Limitation: Foreign Source Taxable Income 50,000 / World-wide Taxable Income 100,000 x U.S. IncomeTax before FTCs 34,000 = FTC Limit (by basket) 17,000

Allowed FTC (Lesser of Actual vs Limit) (17,000) 17,000

Residual (net) U.S. Income Tax Liability $17,000

FTC Carryforwards 3,000 3,000

Example: single basket


US 1120 ---US Source--- General Limitation Passive

Taxable Income $100,000 50,000 30,000 20,000 U.S. Tax Liability Before FTCs $34,000

Potential Foreign Tax Credits: Sec. 901 Direct Credits 1,000 4,000 Sec. 902 Deemed Paid FTCs 15,000 Total Potential FTCs 16,000 4,000

FTC Limitation: Foreign Source Taxable Income 30,000 20,000 / World-wide Taxable Income 100,000 100,000 x U.S. IncomeTax before FTCs 34,000 34,000 = FTC Limit (by basket) 10,200 6,800

Allowed FTC (Lesser of Actual vs Limit) (14,200) 10,200 4,000

Residual (net) U.S. Income Tax Liability $19,800

FTC Carryforwards 5,800 5,800 -

-----Foreign Source-----

Example: separate baskets


Agenda

• Introduction• Source of income rules • Credit limitations• Indirect credit• Changes to FTC

QuestionsContinue

Or


Credit limitation – foreign losses

• Separate Limitation Loss Reclassification– Losses in separate basket allocated against foreign source income

in other baskets before being allocated against U.S. source income– Recharacterization or recapture in proportion to prior loss allocation

• Overall Foreign Loss– Overall foreign loss (after consideration of separate limitation loss

reclassification) offsets U.S. source income in current year– The lower of a) The amount of foreign losses used to offset U.S.

source income in a prior year or b) 50% of the current year’s net foreign source income is recaptured in subsequent years as U.S. source income


Credit limitation – U.S. losses

U.S. Source Loss

An overall domestic loss (“ODL”), to the extent that it does not exceed the foreign source separate limitations for such year, is allocated among such incomes on a proportionate basis

2007 regulations added recapture rules for ODL accounts - ODL recapture happens after OFL recapture and SLL recharacterization.


Resourcing U.S. income

U.S. source income may be re-sourced as foreign source income where a taxpayer's foreign tax credit limitation has been reduced due to an overall domestic loss. IRC § 904(g)


Example: separate loss allocation - old separate basket rules

General Limitation

Passive Shipping FSC Dividends

Financial Services

2005 Results -800 160 320 200 120

2005 Separate Limitation Loss Application

800 -160 -320 -200 -120

2006 Results 600

Recapture of Separate Limitation Losses600 x (160/800)

-120 120

600 x (320/800) -240 240

600 x (200/800) -150 150

600 x (120/800) -90 90


Agenda



Indirect credit

• An "indirect credit" or "deemed paid tax" is allowed under IRC § 902 for:– Domestic corporation who receives dividends from foreign

corporation; and– Domestic corporation owns at least 10% of foreign corporation's

voting stock • An "indirect credit" is also allowed under IRC § 960 for:

– Domestic corporation who includes income from foreign corporation under IRC § 951, such as subpart F or investment in U.S. property; and

– Domestic corp directly owns at least 10% of foreign corp's voting stock

– Domestic shareholder is deemed to have paid the foreign taxes of the foreign corporation attributable to the earnings from which the dividend is paid


Indirect credit

For example, if foreign corporation A distributes one fourth of its earnings and profits as a dividend to its shareholder, domestic corporation X, X is deemed to have paid one forth of A's foreign income taxes

Under IRC § 78, a domestic corporation taking a IRC § 902 credit must include additional dividend income equal to the amount of the deemed paid taxes


CORPORATIONU.S. Tax Return Foreign CorporationU.S. source income $1,000 Foreign profit before tax $600Foreign dividend (600 – 180) $ 420Taxable income before gross-up $1,420 Foreign income tax $180§ 78 gross-up, $ 180Taxable income after gross-up $1,600

Indirect credit


Indirect credit

Foreign taxes deemed paid under IRC §§ 902 and 960 are creditable subject to the limitations of IRC § 904

Therefore, the dividend and taxes must be allocated among the separate limitation income categories, or baskets, under IRC § 904(d)


Indirect credit

• A first-tier foreign subsidiary receiving a dividend from a second tier foreign corporation is deemed to have paid a prorata share of the foreign income tax paid by the second tier foreign corp if– 1st tier corp owns ≥ 10 % of the voting stock of 2nd tier foreign

corp.

• The indirect credit is limited to 6 tiers of foreign corporations

• If the foreign corp is more than three tiers removed from the taxpayer, the foreign corp must be a controlled foreign corp


Indirect credit for Post 86 distribution

• For tax years beginning after 1986, the amount of the indirect tax credit attributable to dividends and Subpart F income inclusions is generally based on pro rata share of post-1986 foreign income taxes, as determined by the ratio of the dividend or Subpart F inclusion to the foreign corporation’s aggregate pool of post-1986 undistributed earnings and profits

• A similar amount is included in the gross income of the recipient corporation as dividend income under Sec. 78

• The effect of aggregating foreign taxes paid and undistributed earnings and profits is to make the indirect credit reflect the average rate of tax paid by the foreign corporation over a period of years


Indirect credit for Pre 87 distribution

• IRC § 902(c)(6) provides that dividends paid by a foreign corporation from accumulated earnings and profits for tax years beginning before 1987 are subject to the rules of IRC § 902 as they existed prior to the Tax Reform Act of 1986.

• For the pre-1987 tax years, the foreign corporation’s earnings and profits are treated as being distributed on a last-in, first-out basis. The foreign taxes paid each year are associated with each layer of earnings and profits.


Indirect credit FTC formula

Dividend from Post-86 E&P PoolsLocal Currency Dividend X Post-86 Pool of Local Currency Post-86 E&P Foreign Taxes(in US$) 1

Dividend from Pre-87 E&P PoolsSec 902 Local Currency Dividend X Annual Layer of

Local Currency E&P For Year Foreign Taxes Paid 2

Sec. 960 Local Currency Dividend X Annual Layer of Local Currency E&P For Year Foreign Taxes Paid 3

1 Translate into US$ using the average exchange rate for the tax year2 Translate into US$ at spot rate on date of dividend3 Translate into US$ at average exchange rate for E&P year


Example: indirect credit

• Facts– U.S. Co receives $120 from UKCo– U.S. Co owns 40% of UKCo – U.K. Co’s post-86 E&P total is $1,200– U.K. Co paid $500 in foreign taxes

• Results– U.S. Co recognizes $50 additional gross income

(120/1,200 X 500 = 50) - Sec.78 Gross Up

• U.S. Co is deemed to have paid $50 in foreign taxes, relative to the dividend income


Credit allowed to foreign persons

• Only in rare circumstances is a FTC allowed to non-resident alien individuals or to foreign corporations under IRC § 906– A foreign person with a U.S. trade or business, including foreign

sourced income, is allowed a FTC against U.S. tax on that income– A foreign tax on U.S. sourced income effectively connected with a

U.S. trade or business is potentially creditable if;

1. Country imposing tax is not taxpayer's country of residence, incorporation or domicile; or

2. The foreign tax, if imposed by taxpayer's country of residence, incorporation or domicile would have been levied even without such tie to the U.S.


International boycotts participants

• The FTC is reduced for each year in which the taxpayer either participates or cooperates with an international boycott– Actions of one member of a controlled group impact the

entire group– Generally the entire tax pool is reduced by the boycott

factor• (boycott operations / all non-U.S. operations)

– Credit denial only extends to taxes specifically attributable to the operations • Related to the boycott activity IRC § 999


Credit against AMT

• A FTC is allowed in determining AMT under IRC § 55

• FTC limitations under IRC § 904 are re-calculated under AMT rules, by basket

• Foreign income taxes made non-creditable by IRC § 904, as modified by the AMT rules, are carried forward or back to be used under AMT rules in that year


Agenda



Accrual and adjustments to foreign tax

Generally, IRC § 905 modifies normal accounting in two ways• Allows accrual of FTC, regardless of taxpayer's general

method of accounting;• Modifies annual accounting concept for foreign taxes

– Subsequent adjustments to tax may require amending the "credit year" return


Accrual of foreign tax

Generally, IRC § 905(a) allows accrual of foreign taxes for credit purposes• Taxpayer electing to accrue must adhere to such for all subsequent

years;– Only applicable to years of FTC under IRC § 901

• A FTC generally accrues during the year for which it is imposed– Example: a country A tax on year 1 income usually accrues in year

1, even if no return or payment is due in country A until year 2.• An accrued tax not paid within two years is only deductible when paid• A foreign tax does not accrue if the taxpayer is not compliant w/ foreign

law• For years of deduction, taxpayers general method determines the

deduction


Changes to direct foreign tax

• Generally, under IRC § 905(c)(1) the FTC is adjusted if:– The tax paid differs from the amount claimed as credit– Accrued taxes are not paid within two years after the

close of the tax year– Tax is refunded

• In adjusting the credit, the adjustment must be related to the separate limitation categories under IRC § 904(d)

• Redetermination impacting prior period FTC requires IRS to be notified


Changes to indirect foreign

• The Treasury has provided in regulations that the redeterminations of a foreign corporation's income taxes are made prospectively, subject to several exceptions, including:– Indirect credits are retroactively adjusted if the FC

receives refund otherwise causing a deficit in post 86 foreign income taxes;

– Redeterminations of tax paid in a country with hyperinflationary currency

• In adjusting the credit, the adjustment must be related to the separate limitation categories under IRC § 904(d)


The foreign tax credit is elective

• Taxpayer losses the deduction otherwise allowed by IRC § 164(a) for foreign taxes

• Choice of credit or deduction applies to all foreign income taxes for the year

• May alternate between credit or deduction from year to year• Election may be revoked any time before statute on refunds

runs out


Filing and substantiation

Procedural requirements for taking a FTC include:• Election made by including Form 1116 (individuals) or 1118

(corps) • Receipt for payment or copy of tax return reporting the

liability• IRS may require a bond to be filed as a condition precedent

to credit• IRC § 6038(a) information reporting for a controlled

corporation– Failure to file can result in a reduction of foreign tax

credits


Contact Information

Randy Free

Partner – SoCal International Tax Practice Leader

Grant Thornton LLP

18400 Von Karman Ave, Suite 900

Irvine, California 92612

949.608.5311 (office)

949.606.6859 (cell)

[email protected]

Tax Professional Standards StatementThis document supports Grant Thornton LLP’s marketing of professional services, and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

cite foreign tax credit presentation by randy free january 2011

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