cite foreign tax credit presentation by randy free january 2011

Cite Foreign Tax Credit Presentation By Randy Free January 2011 - Presentation Transcript

1. CITE: US International Tax Reporting & Compliance - 2011Computing Direct and

Indirect Foreign Tax Credit BenefitsJanuary 24, 2011Randy FreePartner - International

Tax ServicesGrant Thornton, LLPIrvine, CaliforniaTelephone: (949) 608-

[email protected]© Grant Thornton LLP. All rights reserved.

2. Circular 230 DisclosureTo 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.© Grant Thornton LLP. All

rights reserved. 3

4. Agenda• Introduction• Source of income rules• Credit limitations• Indirect credit•

Changes to FTC© Grant Thornton LLP. All rights reserved. 4

5. 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© Grant Thornton LLP. All rights reserved. 5

6. U.S. taxation without FTCU.S. Tax Return Foreign Country Tax ReturnForeign source

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

x .25U.S. income tax $ 350 Foreign income tax $ 250U.S. tax $350Foreign tax

$250Worldwide tax $600Worldwide ETR 60.00% [$600/$1,000]© Grant Thornton LLP.

All rights reserved. 6

7. U.S. taxation with FTCU.S. Tax Return Foreign Country Tax ReturnForeign source

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

$1,000 x .35 x .25U.S. income tax $ 350 Foreign income tax $ 250Less FTC <

250>U.S. tax after FTC $ 100U.S. tax $100Foreign tax $250Worldwide tax

$350Worldwide ETR 35% [$350/$1,000]© Grant Thornton LLP. All rights reserved. 7

8. Double tax minimizationFTC 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© Grant Thornton LLP. All rights reserved. 8

9. Taxes against which credit allowedGenerally, 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© Grant Thornton LLP. All rights

reserved. 9

10.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© Grant Thornton LLP. All rights reserved. 10

11.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© Grant Thornton LLP. All rights reserved. 11

12.Creditable foreign taxesCreditable 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; and 2. 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© Grant Thornton LLP. All rights reserved. 12

13.Non-creditable foreign income taxesGenerally, 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© Grant Thornton

LLP. All rights reserved. 13

14.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• Taxpayers worldwide tax liability on foreign

source income equals the greater of – Pre-credit U.S. tax on the income; or – Foreign

income tax© Grant Thornton LLP. All rights reserved. 14

15.Overall limitation Foreign Source Foreign Tax Taxable Income U.S. Tax Credit Limit =

World Wide x Before FTC Taxable Income• Allowed FTC is the lesser of 1. Creditable

Foreign Income Taxes, or 2. 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© Grant Thornton LLP. All rights reserved. 15

16.Credit limitation - generally Foreign Tax U.S. Tax Return 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© Grant Thornton LLP. All rights reserved. 16

17.Agenda• Introduction• Source of income rules• Credit limitations• Indirect credit•


18.Source of income rules Income Type Source Rule Reference Dividends Residence of

payor; unless, IRC § 861(a)(2) foreign company earns 25% or IRC § 862(a)(2) more

ECI over 3-year period Interest Residence of obligor; unless, IRC § 861(a)(1) domestic

obligor (so called IRC § 862(a)(1) “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)) Rents and Location of tangible property; IRC § 861(a)(4) Royalties

place of exploitation of IRC § 862(a)(4) intangible property© Grant Thornton LLP. All

rights reserved. 18

19.Source of income rulesIncome Type Source Rule ReferenceManagement Fees Place

where services are performed IRC § 861(a)(3) IRC § 862(a)(3)Gains from Personal

Residence of seller IRC § 865(a)Property Sales (e.g.,Capital Gains)Gain on Sale of

Foreign source if sale occurs in the IRC § 865(f)Foreign Affiliate Stock foreign country

and at least 50% of affiliate’s income over past three years is derived from active

business in its countryGain on Sale of Residence of seller; unless, contingent IRC §§

865(d)Intangibles on productivity or use of the intangible and (h) (if so, source rule for

royalty controls); Foreign source if treaty applies© Grant Thornton LLP. All rights

reserved. 19

20.Source of income rulesIncome Type Source Rule ReferenceGain on Sale of Place of

sale (Exception applies to IRC § 861(a)(6)Purchased Inventory purchases in U.S.

possessions) See IRC § 862(a)(6)Property Treas. Reg. §1.863-3(f))Gain on Sale of

Generally 50/50 between production IRC §863(b)Produced Inventory and sales

activitiesPropertyInterest, Dividends and Look-thru rule - Foreign if so IRC §

904(g)Subpart F Inclusions from prescribed under normal rules forcontrolled foreign

interest and dividend income; unless,corporations attributable to payor’s income from

U.S. sources© Grant Thornton LLP. All rights reserved. 20

21.FTC limitation – old separate basket rules1. Passive Income (i.e. interest, rents,

royalties, etc.)2. High Withholding Tax Interest (i.e. subject to withholding tax ≥ 5%)3.

Financial Services Income4. Shipping Income5. Certain dividends received from non-

controlled section 902 foreign corporations (10/50 corporations) (eliminated post 2002,

look-thru applies AJCA 2004)6. Certain DISC dividends7. Taxable income related to

certain foreign trade income8. Certain FSC dividends9. All other income (i.e., the

general limitation)© Grant Thornton LLP. All rights reserved. 21

22.FTC limitation – new separate basket rulesEffective for tax years beginning after

December 31, 2006, thenumber of foreign tax credit limitation categories or basketshas

been reduced to two: passive income and generalcategory income IRC § 904(d)(1)©

Grant Thornton LLP. All rights reserved. 22

23. 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© Grant Thornton LLP. All rights reserved. 23

24.Separate basket limitation Foreign Source Foreign Tax Taxable Income U.S. Tax Credit

Limit = x Before FTC Within Basket World Wide Taxable Income© Grant Thornton LLP.


25.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© Grant Thornton LLP. All rights reserved. 25

26.Example: 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© Grant Thornton LLP. All rights reserved. 26

27.Example: separate baskets -----Foreign Source----- 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 -© Grant

Thornton LLP. All rights reserved. 27

28.Agenda Or Continue Questions• Introduction• Source of income rules• Credit limitations•

Indirect credit• Changes to FTC© Grant Thornton LLP. All rights reserved. 28

29.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© Grant Thornton LLP. All rights reserved. 29

30.Credit limitation – U.S. lossesU.S. Source LossAn overall domestic loss (“ODL”), to the

extent that it does notexceed the foreign source separate limitations for such year,is

allocated among such incomes on a proportionate basis2007 regulations added

recapture rules for ODL accounts -ODL recapture happens after OFL recapture and

SLLrecharacterization.© Grant Thornton LLP. All rights reserved. 30

31.Resourcing U.S. incomeU.S. source income may be re-sourced as foreign

sourceincome where a taxpayers foreign tax credit limitation hasbeen reduced due to

an overall domestic loss. IRC § 904(g)© Grant Thornton LLP. All rights reserved. 31

32.Example: separate loss allocation - old separatebasket rules General Passive Shipping

FSC Financial Limitation Dividends Services2005 Results -800 160 320 200 1202005

Separate Limitation 800 -160 -320 -200 -120Loss Application2006 Results

600Recapture of Separate -120 120Limitation Losses600 x (160/800)600 x (320/800) -

240 240600 x (200/800) -150 150600 x (120/800) -90 90© Grant Thornton LLP. All

rights reserved. 32



34. 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 corporations 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

corps 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©

Grant Thornton LLP. All rights reserved. 34

35. Indirect creditFor example, if foreign corporation A distributes one fourth ofits earnings

and profits as a dividend to its shareholder,domestic corporation X, X is deemed to have

paid one forth ofAs foreign income taxesUnder IRC § 78, a domestic corporation taking

a IRC § 902credit must include additional dividend income equal to theamount of the

deemed paid taxes© Grant Thornton LLP. All rights reserved. 35

36. Indirect credit 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© Grant Thornton LLP. All rights reserved. 36

37. Indirect creditForeign taxes deemed paid under IRC §§ 902 and 960 arecreditable

subject to the limitations of IRC § 904Therefore, the dividend and taxes must be

allocated amongthe separate limitation income categories, or baskets, underIRC §

904(d)© Grant Thornton LLP. All rights reserved. 37

38. 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© Grant Thornton LLP. All rights reserved. 38

39. 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© Grant Thornton LLP. All rights reserved. 39

40. 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.© Grant Thornton LLP.


41. Indirect credit FTC formulaDividend from Post-86 E&P Pools Local Currency Dividend X

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

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

E&P For Year Foreign Taxes Paid 2Sec. 960 Local Currency Dividend X Annual Layer

of Local Currency E&P For Year Foreign Taxes Paid 31 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© Grant Thornton


42.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© Grant Thornton LLP. All rights reserved. 42

43.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 taxpayers country of residence, incorporation or domicile; or 2. The foreign

tax, if imposed by taxpayers country of residence, incorporation or domicile would have

been levied even without such tie to the U.S.© Grant Thornton LLP. All rights reserved.

43

44. 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© Grant Thornton LLP. All rights reserved. 44

45.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© Grant Thornton LLP.




47.Accrual and adjustments to foreign taxGenerally, IRC § 905 modifies normal accounting

in two ways• Allows accrual of FTC, regardless of taxpayers general method of

accounting;• Modifies annual accounting concept for foreign taxes – Subsequent

adjustments to tax may require amending the "credit year" return© Grant Thornton LLP.


48.Accrual of foreign taxGenerally, 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© Grant Thornton LLP. All rights

reserved. 48

49.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© Grant

Thornton LLP. All rights reserved. 49

50.Changes to indirect foreign• The Treasury has provided in regulations that the

redeterminations of a foreign corporations 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)© Grant Thornton LLP. All rights reserved. 50

51.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© Grant Thornton


52.Filing and substantiationProcedural 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© Grant Thornton LLP. All

rights reserved. 52

53.Contact InformationRandy FreePartner – SoCal International Tax Practice LeaderGrant

Thornton LLP18400 Von Karman Ave, Suite 900Irvine, California 92612949.608.5311

(office)949.606.6859 (cell)[email protected]© Grant Thornton LLP. All rights

reserved.

54.Tax Professional Standards StatementThis document supports Grant Thornton LLP’s

marketing of professional services, and is not written tax advice directed at theparticular

facts and circumstances of any person. If you are interested in the subject of this

document we encourage you to contact usor an independent tax advisor to discuss the

potential application to your particular situation. Nothing herein shall be construed

asimposing a limitation on any person from disclosing the tax treatment or tax structure

of any matter addressed herein. To the extentthis document may be considered to

contain written tax advice, any written advice contained in, forwarded with, or attached

to thisdocument is not intended by Grant Thornton to be used, and cannot be used, by

any person for the purpose of avoiding penaltiesthat may be imposed under the Internal

Revenue Code.

cite foreign tax credit presentation by randy free january 2011

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