Cite Foreign Tax Credit Presentation By Randy Free January 2011

CITE: US International Tax Reporting & Compliance - 2011

Computing Direct and Indirect Foreign Tax Credit Benefits

January 24, 2011

Randy Free
Partner - International Tax Services
Grant Thornton, LLP
Irvine, California
Telephone: (949) 608-5311
randy.free@us.gt.com

© Grant Thornton LLP. All rights reserved.

Circular 230 Disclosure

To ensure compliance with requirements imposed by
the IRS, any U.S. federal tax advice contained in this
document is not intended or written to be used, and
cannot be used, for the purpose of (i) avoiding
penalties under the Internal Revenue Code or (ii)
promoting, marketing, or recommending to another
party any transaction or matter that is contained in
this document.


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


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. taxation without FTC

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 $350
Foreign tax $250
Worldwide tax $600

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


U.S. taxation with 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 $ 250
Less FTC < 250>
U.S. tax after FTC $ 100

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

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


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; 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

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

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

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

Agenda

• Introduction
• Indirect credit
• Changes to FTC


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


Management 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
country
Gain 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


Gain 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 activities
Property
Interest, Dividends and Look-thru rule - Foreign if so IRC § 904(g)
Subpart F Inclusions from prescribed under normal rules for
controlled foreign interest and dividend income; unless,
corporations attributable to payor’s income from
U.S. sources


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 Source
Foreign Tax Taxable Income U.S. Tax
Credit Limit = x Before FTC
Within Basket
World Wide
Taxable Income


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


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


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 -


Agenda Or

Continue Questions

• Introduction
• Indirect credit
• Changes to FTC


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 Passive Shipping FSC Financial
Limitation Dividends Services
2005 Results -800 160 320 200 120
2005 Separate Limitation 800 -160 -320 -200 -120
Loss Application
2006 Results 600
Recapture of Separate -120 120
Limitation Losses
600 x (160/800)
600 x (320/800) -240 240
600 x (200/800) -150 150
600 x (120/800) -90 90


Agenda

• Introduction
• Indirect credit
• Changes to FTC


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


Indirect credit

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


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

Dividend from Pre-87 E&P Pools
Sec 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 year
2 Translate into US$ at spot rate on date of dividend
3 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

• Introduction
• Indirect credit
• Changes to FTC


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)
Randy.Free@US.gt.com


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that may be imposed under the Internal Revenue Code.

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