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Cite Foreign Tax Credit Presentation By Randy Free January 2011
 

Cite Foreign Tax Credit Presentation By Randy Free January 2011

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General overview of the foreign tax credit mechanics

General overview of the foreign tax credit mechanics

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

    • CITE: US International Tax Reporting & Compliance - 2011Computing Direct and Indirect Foreign Tax Credit BenefitsJanuary 24, 2011Randy FreePartner - International Tax ServicesGrant Thornton, LLPIrvine, CaliforniaTelephone: (949) 608-5311randy.free@us.gt.com© Grant Thornton LLP. All rights reserved.
    • 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.
    • 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
    • Agenda• Introduction• Source of income rules• Credit limitations• Indirect credit• Changes to FTC© Grant Thornton LLP. All rights reserved. 4
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • Agenda• Introduction• Source of income rules• Credit limitations• Indirect credit• Changes to FTC© Grant Thornton LLP. All rights reserved. 17
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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. All rights reserved. 24
    • 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
    • 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
    • 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
    • Agenda Or Continue Questions• Introduction• Source of income rules• Credit limitations• Indirect credit• Changes to FTC© Grant Thornton LLP. All rights reserved. 28
    • 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
    • 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
    • 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
    • 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
    • Agenda• Introduction• Source of income rules• Credit limitations• Indirect credit• Changes to FTC© Grant Thornton LLP. All rights reserved. 33
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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. All rights reserved. 40
    • 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 LLP. All rights reserved. 41
    • 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
    • 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
    • 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
    • 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. All rights reserved. 45
    • Agenda• Introduction• Source of income rules• Credit limitations• Indirect credit• Changes to FTC© Grant Thornton LLP. All rights reserved. 46
    • 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. All rights reserved. 47
    • 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
    • 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
    • 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
    • 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 LLP. All rights reserved. 51
    • 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
    • Contact InformationRandy FreePartner – SoCal International Tax Practice LeaderGrant Thornton LLP18400 Von Karman Ave, Suite 900Irvine, California 92612949.608.5311 (office)949.606.6859 (cell)Randy.Free@US.gt.com© Grant Thornton LLP. All rights reserved.
    • 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.