Foreign Tax Credit
There are many instances in which an individual or entity may be subject to tax in two or more countries. For instance, one country may tax on worldwide income (as is the case in the US) whereas another may have a territorial tax regime. Two countries may have different definitions of residence thereby creating dual-resident individuals or entities. Two countries may have differing sourcing rules.
Mitigating Dual Taxations
In order to reduce dual taxation there are a number of possible mechanisms that can be applied:
Tax Treaties: A tax treaty between two countries can specify that certain income is only taxed in one jurisdiction. Tax treaties can also establish the prevailing residence rules that apply between the two countries.
Exemption: One country can exempt income that is taxed in another jurisdiction (the US applies this to a limited extent with respect to expatriates (as we saw in week 2).
Tax Credit: Tax liability can be offset by the amount of foreign taxes paid in another jurisdiction.
Tax Deduction: A tax deduction can be available to the extent of foreign taxes paid in another jurisdiction (remember that a tax deduction is not a beneficial as a tax credit).
Where a treaty does not provide relief, the primary method of mitigating dual taxation in the US is the Foreign Tax Credit (FTC). The FTC is only available for Income Taxes paid in foreign countries. All other taxes (such as excise taxes) are not creditable but they may be deductible.
Direct and Indirect Foreign Tax Credit
When an individual or entity pays taxes to a foreign jurisdiction they are entitled to a Direct FTC on the amount they paid (subject to some limitations that we will discuss next week). However, US shareholders may be entitled to an Indirect FTC on the foreign taxes paid by a CFC. In this case the payment of the foreign taxes is made by the foreign corporation, not the US shareholder, however a FTC is still potentially available indirectly.
The calculation of the indirect FTC may appear complicated but it can be reduced to a simple 4 step process. Remember when we discussed the Branch Profits Tax we formulated a “dividend equivalent amount” so that the branch would be treated as a subsidiary. Here we are doing the opposition, we are reformulating the transaction so that is appears as though the US corporation is receiving the income directly through a branch instead of indirectly from a subsidiary.
Assume that a US corporation (USCo) owns 50% of a Foreign Corporation (ForCo) and the remaining 50% is earned by other US shareholders. ForCo is a CFC because more than 50% is owned by US shareholders.
ForCo earns $100,000 of Subpart F income and ForCo pays the $30,000 of foreign income tax. In the same year ForCo makes an actual distribution of $50,000 to all its shareholders.
Since the $100,000 income is Subpart F income it is deemed to be a distributed to all the US shareholders in the year it is received regardless of the actual amount distributed.
Although the US shareholders (including USCo) did not pay any foreign taxes on the $100,000 they are nonetheless entitled to an indirect FTC on the $30,000 paid by ForCo.
Basically, we treat it as if USCo and the other US shareholders earned the $100,000 income directly and then paid the Foreign Tax instead of ForCo.
Remember that there is a deemed dividend to the extent of Subpart F. So even if ForCo may only have made a $50,000 dividend payment, for tax purposes we will treat it as if ForCo made a dividend payment of all its post-tax Subpart F income. In this case $70,000 (the amount of income remaining after paying the $30,000 foreign tax) is deemed to have been paid as a dividend to the US shareholders. Since USCo owns 50% of ForCo, USCo is deemed to have received a dividend of $35,000. The four-step calculation would be as follows:
(Dividend Amount Received by USCo ($35,000) / ForCo earnings ($70,000)) X Foreign Tax Paid by ForCo ($30,000) = Tax Deemed Paid by USCo (50% X $30,000 = $15,000)
Tax Deemed Paid ($15,000) + Dividend Amount ($35,000) = Grossed-up Amount ($50,000)
Grossed-up Amount ($50,000) X US Tax Rate (35%) = Pre-Credit US Tax ($17,500)
Pre-Credit US Tax ($17,500) – Tax Deemed Paid ($15,000) = Tax Liability ($2,500)
Assume the same facts as in Example 1, except now assume that the $100,000 is non-Subpart F income instead of Subpart F income. In this case USCo is not entitled to a foreign tax credit even though ForCo paid foreign tax and USCo received an actual dividend of $25,000 from the income that was subject to foreign tax.
Prior to 2017, USCo would have been entitled to an indirect foreign tax credit on the foreign taxes paid. However, the Tax Cut and Jobs Act of 2017 no longer allows it.
Assume the same facts as in Example 2 (ForCo’s income is non-Subpart F income once again). But this time, ForCo’s country imposes a withholding tax of 1% on dividend payments paid to USCo. So the dividend payment of $25,000 to USCo is subject to a withholding tax of $250. Note that this tax is a shareholder level income tax (not a foreign corporation level income tax). Hence it is paid DIRECTLY by USCo (the shareholder) and a foreign tax credit is permited for the $250 of foreign taxes paid by USCo.
Foreign Tax Credit Limitations
Last week we discussed which taxes are eligible for the foreign tax credit and how the indirect foreign tax credit works. This week we will focus on the limitations of the foreign tax credit. Let’s start by considering the following example:
Assume that T, a US person, earns $1200 from the US and France. $500 is deemed to be US source income and $700 is deemed to be foreign source income. France imposes a tax of 60% on the $700 that was earned in France, resulting in $420 of French tax. T’s US tax liability would be as follows if there were no limitations on the amount of FTC he could use:
Gross Income: $1200
Taxable Income: $1200
US Tax rate: 35%
Pre-credit US Tax Liability: $420
Foreign Tax Credit: ($420)
Tax Liability: $ 0
Notice that the FTC not only offset the US tax on the $700 of Foreign Source income, but also completely reduced the tax on the US source income to Zero. As a result of the FTC the US Treasury was unable to collect tax on US source income – income upon which no foreign tax was imposed and to which the US government believes it is entitled to in its entirety.
For this reason, the tax code limits the FTC to foreign source income. This is reflected in the FTC Limitation calculation as follows:
Permitted FTC = (Foreign Source Income / Worldwide Income) X Pre-Credit US Tax
So in the example above, the outcome would be as follows:
Permitted FTC = ($700 / $1200) X $420 = $245
Since the Permitted FTC is only $245, the US Tax Liability would be $175 ($420 – $245). Notice that now the US Treasury is able to collect tax on the US source income at the regular US tax rate of 35%: $175 (Tax Liability) / $500 (US source income) = 35%.
Now you can see why the distinction between US source income and foreign source income (that we discussed in week 2) is so important for US taxpayers. Even though they are subject to tax on Worldwide Income, their FTC amount is dictated by the amount of US and foreign source income.
In our example above, the FTC Limitation only allowed T to take a FTC on $245 of the $420 of foreign taxes paid. What happens to the additional $175 that was in excess of the limitation? T can potentially use it in prior years or subsequent years. Let’s take a look at how that would work with this new set of facts:
Assume that the current year is 2003 and the taxpayer had the following tax credit position after performing the FTC Limitation formula:
Foreign Taxes Paid: $830
FTC Limitation: $100
The effective tax rate on the foreign source income was much higher than the US tax rate, so T was only able to credit $100 of the $830 of foreign taxes paid. T has an excess FTC of $730. First we look at his tax position in the previous year (2002).
Foreign Taxes Paid: $75
FTC Limitation: $175
In 2002, the effective tax rate on foreign source income must have been lower than the US tax rate since the limitation was much higher than the amount of foreign taxes paid. Since the FTC limitation exceeds the foreign taxes in 2002 by $100, T can apply part of the $730 of excess credit in 2002. T would file an amended return for 2002 and declare $175 of FTC instead of only $75. Now T only had $630 of excess FTC. The next step is to look at 2004. When 2004 comes around T determines that his FTC position is as follows:
Foreign Taxes Paid: $60
FTC Limitation: $150
Like in 2002, the effective tax rate on foreign source income must have been lower than the US tax rate. Since the FTC limitation exceeds the foreign taxes in 2004 by $90, T can apply part of the $630 of excess credit in 2004. On T’s 2004 return T would take $150 of FTC and now his excess FTC credit is $540. We can carry this excess FTC forward for 10 years after the year it was realized (so until 2013 for the foreign taxes paid in 2003).
You will note that the book says that you carryback 2 years and then carryforward 5 years. This is the old rule. The American Jobs Creation Act of 2004 changed this so that now you can carryback 1 year and carryforward 10 years.
Separate Basket Limitations
The tax authorities noticed that even with the FTC limitation, there was potential for abuse. Consider the following scenario:
USCo, a US corporation, has the following income in 2005:
$100 of US source active business income
$100 of US source investment income
$100 of foreign source active business income subject to foreign tax at a rate of 45%, resulting in $45 of foreign tax.
If the US tax rate is 35%, USCo’s US tax position is as follows:
Gross Income: $300 (Worldwide income)
Taxable Income: $300
Tax Rate: 35%
Pre-credit US Tax: $105
There was $45 of foreign taxes, but first we must apply the FTC limitation to determine how much of that is creditable:
Permitted FTC: (Foreign source income ($100) / WW Income ($300)) X Pre-credit US Tax ($105) = 100/300 X 105 = $35
Since the FTC is $35, USCo’s tax liability in 2005 is $70 ($105-$35). Of course, the $10 of excess FTC can be carried back a year and then carried forward 10 years.
Now assume that USCo made one simple change. Assume that it moved its investment portfolio offshore so that instead of having a portfolio of US stocks that produces US source income, it now has a portfolio of foreign stocks that produces foreign source income (that is not subject to foreign taxes). Remember from our earlier discussions that this can be done effortlessly by giving a few instructions to the broker. However, this simple step can significantly alter USCo’s tax position. Now that the investment income is foreign source income, the FTC Limitation is as follows:
Permitted FTC: (Foreign source income ($200) / WW Income ($300)) X Pre-credit US Tax ($105) = 200/300 X 105 = $70
Notice that the numerator (foreign source income) in the FTC Limitation calculation has changed and now USCo can credit the entire $45 of foreign taxes paid since it falls below the $70 FTC Limitation. So now USCo’s Tax Liability is only $60 ($105-$45). Be careful to note that even if the FTC Limitation exceeds the amount of foreign taxes paid, the taxpayer can only credit the amount of foreign taxes paid (a common mistake is to credit the entire FTC Limitation amount).
Because of this potential for abuse by shifting the source of investment income, the tax code requires that the FTC Limitation calculation be performed separately for different categories of income.
Although there used to be a number of different categories (or “baskets”), the American Jobs Creation Act of 2004 has basically narrowed it down to two: passive income (which is essentially FPHC income) and other income (which includes active business income).
So in the above example we would have to perform two limitation calculations:
FTC Limitation for Passive Income = (Foreign Source Passive Income ($100) / Worldwide Income ($300)) X Pre-credit US tax ($105) = $35
FTC Limitation for Active Income = (Foreign Source Active Income ($100) / Worldwide Income ($300)) X Pre-credit US tax ($105) = $35
Since the FTC Limitation for Active Income is $35, we could only credit $35 of the $45 of foreign taxes paid on the active income.
Since no foreign taxes were actually paid on the foreign passive income, we would not take any FTC in the passive basket and we would have an excess credit of $35 which we can carryback and carryforward to credit foreign taxes paid on passive income in previous or subsequent years.
As you can see, this neutralizes the benefits that were derived from shifting the portfolio income offshore.