Final Maximizing Foreign Tax Credits

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Planning and Compliance after Tax Cuts Jobs Act

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Maximizing Foreign Tax Credits: Planning and Compliance after Tax Cuts Jobs Act

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Maximizing Foreign Tax Credits


William J Seeger, Ph.D.

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3Maximizing Foreign Tax Credits:


U.S. Framework: Foundations

• Worldwide taxation

• Elimination of double taxation

• FTC

• Source

• Deferral



International tax systems

• Territorial - no tax is generally due on income earned outside of the country in which the parent is located

• US based on Worldwide tax system - all income is subject to taxation by the country in which the parent is located

➢ US taxes worldwide income of citizens and permanent residents

➢ US taxes worldwide income of domestic corporations

➢ US taxes the US source income of nonresident aliens

➢ US taxes the US source income of foreign corporations

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Worldwide Taxation

• The U.S. taxes the worldwide income of U.S. corporations (also U.S. individuals, partnerships, estates or trusts) irrespective of where it is earned

• The U.S. corporation is also generally taxed by the other countries where it operates



Eliminating Double Taxation

• A method is needed to mitigate double taxation in order for

• U.S. companies to be competitive

• Two possibilities exist:

➢ exempt foreign source income (adopted by territorial regimes), or

➢ adopt a foreign tax credit (FTC) (adopted by U.S.)

• The U.S. FTC, subject to numerous limitations, allows a company to credits foreign taxes paid $ for $ against its U.S. tax liability

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Source

• U.S. Source Income vs. Foreign Source Income

• U.S.-source income: income determined by tax law to be from within the U.S.

• Foreign-source income: income determined by tax law to be earned outside the U.S.



Foreign Tax Credit

• The foreign tax credit (FTC) is designed to relieve U.S. taxpayers of the burden of double taxation when foreign source income is taxed by both the U.S. and the foreign country from which it is derived.

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Foreign Tax Credits (FTC)

• FTC's objective is to eliminate double taxation on foreign source income

• FTC limitation is designed to provide this relief while eliminating a company's ability to use high foreign tax payments to shelter domestic income

• The FTC limitation is determined (in its most basic form) as follows:



Foreign Tax Credits (FTC)

• Ratio of foreign-source income to worldwide income must not exceed 100%

• FTCs can be carried back 2 years or carried forward 5 years

• Taxpayers have the option of deducting their foreign taxes instead of claiming a foreign tax credit

• Given the process by which the FTC limitation is determined, it becomes critical whether income is designated as U.S. source or foreign source

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The "Deemed Paid" Credit:

• In the case of a FTC for a dividend from a foreign subsidiary, the US parent hasn't actually paid any foreign tax

• In this situation the US parent is considered to have paid the foreign tax actually paid by the subsidiary that relates to the income distributed as a dividend

• The dividend represents only the after-tax amount of the foreign earnings

• The dividend must be "grossed up" to reflect the amount of tax that was paid



Deferral

• A U.S. corporation that is a shareholder in a foreign corporation can defer current U.S. taxation of certain types of income earned abroad until profits are repatriated

• Allows reinvestment of pre U.S. tax earnings

• Deferral is not available to U.S. companies operating abroad as a branch or other flow-through entity

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Antideferral Regimes

• The U.S. tax system (and others) contains constraints on U.S. shareholders' abilities to defer taxes on undistributed (unrepatriated) income (generally passive)

• U.S. shareholders must include in their taxable income certain types of income (Subpart F income and GILTI) earned by controlled foreign corporations (CFCs), regardless of whether or not the income is distributed



US Shareholders and CFCs

• A “U.S. shareholder” is any U.S. person (including a corporation) who owns at least 10% of the voting stock of a foreign corporation

• Both direct and indirect ownership are considered in determining whether the 10% threshold is met

• If all “U.S. shareholders” in aggregate own more than 50% of the shares of the foreign corporation for a period of at least 30 days during the taxable year, that corporation is a CFC (most foreign subsidiaries of U.S. companies) and is subject to the Subpart F rules

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Review Question 1

Maximizing Foreign Tax Credits:Planning and Compliance after Tax Cuts Jobs Act

Foreign Tax Credits

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• The Foreign Tax Credit is a tax benefit that generally allows individuals and businesses to claim a credit for income taxes paid or accrued to foreign governments.

• If you paid or accrued foreign taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.

What is a Foreign Tax Credit?



• Direct credits are foreign taxes paid or accrued by the U.S. taxpayer on foreign branch income, withholding taxes paid on Fixed, Determinable, Annual or Periodic (FDAP) income received, and payments made to a foreign country in the taxpayer’s capacity as a partner in a foreign partnership.

• Indirect or deemed paid credits are for taxes paid by controlled foreign corporations with 10 percent U.S. shareholders for pre-2018 tax years. For post-2017 tax years, indirect or deemed paid credits are for taxes paid by foreign corporations with U.S. shareholders.

There are Two Types of Ftcs:

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• The purpose of the Foreign Tax Credit (FTC) is to provide relief from double taxation.

• A U.S. person is subject to double taxation when income from foreign sources is taxed both by the United Sates and by the foreign country in which the income is earned.

• The credit for foreign income taxes may not exceed the U.S. tax (before the credit) on income from foreign sources.

• The United States does not impose additional tax on foreign source income when the foreign tax rate is higher than the U.S. tax rate.

• Conversely, if the tax rate on the foreign source income is lower than the U.S. tax rate, the FTC causes the overall tax on the foreign income to approximate the U.S. tax rate.

The Purpose of The Foreign Tax Credit



• The foreign tax credit is intended to relieve corporations of the double tax burden when their foreign source income is taxed by both the United States and the foreign country.

• The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.

• There are differences between taking a credit for qualified foreign taxes verses deducting them as an itemized deduction.

• A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax.

Why a Foreign Tax Credit? The Take-Away

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• Generally, only income, war profits

and excess profits taxes qualify for

the credit.

• Taken as a deduction, foreign

income taxes reduce U.S. taxable

income.

• Taken as a credit, foreign income

taxes reduce U.S. tax liability.

• Which one is more advantageous?

Foreign taxes pd= $15

No FTC

Deduction Credit

Sales 200 200 200

COGS 50 50 50

Gross Profit 150 150 150

Operating expenses 50 50 50

FTC (as a deduction) 15

Net Profit 100 85 100

Tax (21%) 21 17.85 21

FTC (as a credit) 15

Net Tax $6

Foreign Taxes Paid as a Credit or a Deduction



Source of IncomeAllocation and Apportionment rules

• Sourcing Income as US Source or Foreign Source is very important for the Foreign Tax Credit Computation.

• A determination must be made as to whether the income is

1. US Source Income- originating from within the US or

2. Foreign Source Income- originating outside of the US

• Income must be properly apportioned between US source and Foreign Source.

• These sourcing rules are governed under IRC 861-865.

• § 1.861-20 provided details guidance on how to match foreign income taxes with income, particularly in the case of differences in how U.S. and foreign law compute taxable income with respect to the same transactions.

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Code Section Description

• 901 Allows direct credit for taxes paid to a foreign country by a U.S. taxpayer based on realized net income.

• 902 Allows deemed paid or indirect credit for foreign taxes based on the proportion of taxes paid by a corporation on its distributed earnings and profits. IRC 902 was repealed by the TCJA for tax years beginning after 2017 but is still effective

for pre-2018 distributions to U.S. shareholders with 10% or greater voting interests in the distributor foreign corporation.

• 903 Allows direct credit for taxes (typically foreign withholding taxes based on gross receipts) paid in lieu of the generally imposed net income tax.

• 904 Limits the amount of credit available in each year, including carryback and carryover of credit.

• 905 Provides guidelines on foreign tax adjustments, redeterminations and proof of credits.

• 906 Allows the foreign tax credit for nonresident alien individuals and foreign corporations engaged in a trade or business in the United States.

• 907 Contains credit limitation for foreign oil and gas income.

• 908 Reduces the FTC for participation in international boycotts.

• 909 Defers the creditability of foreign taxes that are paid in connection with a foreign tax credit splitting event until the taxpayer takes the related income into account.

• 960 Allows an indirect credit for taxes deemed paid with respect to inclusions under IRC 951 or IRC 951A, and certain taxes deemed paid with respect to previously taxed income distributions. (Sub-Part F and GILITI)

• 245A(d) Disallows any claim for FTCs with respect to any dividend for which a deduction is allowed under IRC 245A.

• 245A(e) Disallows any claim for FTCs with respect to hybrid dividends for which a deduction is not allowed under IRC 245A by IRC 245A(e).

This table summarizes the Code sections that authorize and limit the FTC:



FTC Overview

• Generally, four tests must be met for any foreign tax to qualify for the FTC:

1. The tax must be an income tax, or a tax imposed in lieu of an income tax

2. The tax must be a legal and actual foreign tax liability

3. It must be imposed on the taxpayer

4. Taxpayer must have paid or accrued the tax

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What is a Creditable Tax?

• § 1.901-2 Income, war profits, or excess profits tax paid or accrued.

• (a) Definition of income, war profits, or excess profits tax -

▪ (1) In general. Section 901 allows a credit for the amount of income, war profits or excess profits tax (referred to as “income tax” for purposes of this section and §§ 1.901-2A and 1.903-1) paid to any foreign country. Whether a foreign levy is an income tax is determined independently for each separate foreign levy. A foreign levy is an income tax if and only if -

• (i) It is a tax; and

• (ii) The predominant character of that tax is that of an income tax in the U.S. sense.



Must be a Compulsory tax

• Tax must be required by foreign law.

• Taxpayer must challenge any unreasonable taxes.

• Generally, Taxpayer must exhaust all effective and practical remedies before claiming a foreign tax credit.

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https://www.law.cornell.edu/definitions/index.php?width=840&height=800&iframe=true&def_id=1c07283120860b02c14e93d17bce07df&term_occur=999&term_src=Title:26:Chapter:I:Subchapter:A:Part:1:Subjgrp:11:1.901-2

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https://www.law.cornell.edu/definitions/index.php?width=840&height=800&iframe=true&def_id=661fb5529bda5e7b12e0c516a1a1473f&term_occur=999&term_src=Title:26:Chapter:I:Subchapter:A:Part:1:Subjgrp:11:1.901-2


https://www.law.cornell.edu/definitions/index.php?width=840&height=800&iframe=true&def_id=0ad2de56cb198dce23b0b55179137f16&term_occur=999&term_src=Title:26:Chapter:I:Subchapter:A:Part:1:Subjgrp:11:1.901-2

https://www.law.cornell.edu/cfr/text/26/1.901-2A

https://www.law.cornell.edu/definitions/index.php?width=840&height=800&iframe=true&def_id=ca547c524bf28652452f801c274b9624&term_occur=999&term_src=Title:26:Chapter:I:Subchapter:A:Part:1:Subjgrp:11:1.901-2



https://www.law.cornell.edu/definitions/index.php?width=840&height=800&iframe=true&def_id=b064c1a7b8655ab4dd78d036713e277c&term_occur=999&term_src=Title:26:Chapter:I:Subchapter:A:Part:1:Subjgrp:11:1.901-2






Foreign Tax Credits Calculation

• Your (a)foreign tax credit cannot be more than your (b)total U.S. tax liability multiplied by a fraction.

• The numerator of the fraction is your taxable income from sources outside the United States.

• The denominator is your total taxable income from U.S. and foreign sources.



Credit Applicable Only to Taxes

• The following are examples of payments not creditable as taxes:

▪ Penalties, interest, fines and custom duties

▪ Compulsory loans

▪ Amounts reasonably certain to be refunded, credited, rebated, abated, or forgiven

• Principles of U.S. law determine whether a payment is a tax. A payment to a foreign country is not a tax if the payor receives, or will receive, a specific economic benefit in exchange for the payment.

• Soak-up taxes are not creditable. A soak-up tax means that the U.S. taxpayer is liable for the tax only to the extent that the tax is creditable.

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Must Be a Creditable Tax

• The amount of foreign tax that qualifies as a foreign tax credit is not necessarily the amount of tax withheld by the foreign country.

• If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country, only that reduced tax qualifies for the credit.



• A tax not based on income might be a tax on:

• sale,

• turnover,

• transaction,

• output,

• production,

• franchise,

• social security tax on employee wages, asset or property

Tax Must Be Based on "Income"

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Foreign Tax Credit Limitation, Why?

• A foreign tax credit may not be claimed for taxes on income that you exclude from U.S. gross income.

• FTC is taken on income included in US gross income

• However, the amount of the credit is limited to the amount of US tax for that year.

• Any excess credits can be carried back 1 year or carried forward 10 years.

Limitations Carryforward and Carrybacks



Foreign Tax Credit Limitations: Basket History

• Previous FTC Limitation-9 Baskets

• Why create baskets for the limitation?

• What is the aim of separating the credit by baskets?

• Then moved to 2 Baskets

• Now there are 4 baskets• GILTI Basket

• Foreign Branch Income Basket

• Passive Income Basket

• General Income Basket

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• IRC 904- Limitation on Foreign Tax Credit

• IRC 904(d) (1)- FTC Baskets

• (d)Separate application of section with respect to certain categories of income

• (1)In general, the provisions ….shall be applied separately with respect to—

▪ (A)any amount includible in gross income under section 951A (other than passive category income)(GILITI Income)

▪ (B)foreign branch income,

▪ (C)passive category income, and

▪ (D)general category income.

26 U.S. Code § 904 - Limitation on credit- 4 Baskets



How to Claim the Foreign Tax Credit

• Corporations file Form 1118, Foreign Tax Credit—Corporations, to claim a foreign tax credit.

• See IRS Form 1118 and Instructions

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Maximizing Foreign Tax Credits:Planning and Compliance after Tax Cuts Jobs Act

TCJA, FTC, and GILTI



The Tax Cuts and Jobs Act (TCJA)

• TCJA made major changes to the tax law, including revamping the U.S. international tax system.

• Specifically, several Foreign Tax Credit provisions were changed, including repeal of section 902,

▪ which allowed deemed-paid credits in connection with dividend distributions based on foreign subsidiaries' cumulative pools of earnings and foreign taxes.

• TCJA also added two separate limitation categories for foreign branch income and amounts includible under the Global Intangible Low-Taxed Income (GILTI) provisions.

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• Additionally, the TCJA changed how taxable income is calculated for purposes of the Foreign Tax Credit limitation by disregarding certain expenses and repealing the use of the fair market value method for allocating interest expense.

• While section 904 generally allows foreign taxes to be carried back one year and then carried forward ten years, the TCJA does not permit GILTI basket foreign tax credit carrybacks or carryforwards.

• The Final Regulations generally apply the same approach to expense allocation to the GILTI basket as to any other basket.

The Tax Cuts and Jobs Act (TCJA)



• The TCJA made systemic changes to U.S. taxation of international income that impact the Foreign Tax Credit calculation.

• These systemic changes include the introduction of a participation exemption through a dividends received deduction for certain dividends in section 245A and

• The introduction of Global Intangible Low-tax Income (GILTI,) which subjects to current U.S. taxation foreign earnings that would have been deferred under previous law.

The Tax Cuts and Jobs Act (TCJA) and FTC

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• On December 2, 2020 Treasury and the IRS issued final regulations relating to the determination of the foreign tax credit and new proposed regulations providing guidance on

• the allocation and apportionment of deductions and creditable foreign taxes,

• the definition of financial services income,

• foreign tax redeterminations,

• availability of foreign tax credits under the transition tax, and

• the application of the foreign tax credit limitation to consolidated groups.

Foreign Tax Credit Regulations



GLOBAL INTANGIBLE Low-Taxed Income

• Income Inclusion: Similar to Sub-part F

▪ Creates new category of foreign income applicable to U.S.

▪ shareholders that own 10% or more of a CFC

▪ Essentially imposes a minimum level of U.S. tax on foreign Intangible related profits

▪ Excess of U.S. shareholder’s “net CFC tested income” less “net deemed tangible income return” less net interest expense

• Net CFC tested income = excludes several categories of income, including income already subject to U.S. tax as Subpart F or as effectively connected income

• Net deemed tangible income return = 10% of the shareholder’s pro- rata share of the qualified business asset investment (QBAI) of each CFC

─ QBAI is determined as the average of the adjusted U.S. tax basis in specified tangible property that is used in the CFC’s trade or business and is subject to U.S. tax depreciation

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• Full amount is included in a U.S. shareholder’s income, butcorporate shareholders are allowed a deduction equal to 50% ofGILTI

• To get Started:

▪ Allows a U.S. corporation a deduction equal to 37.5%, providing 13.125%effective tax rate, however;

▪ Deduction decreased to 21.875% in 2026

GILTI Deduction



GILTI Context: CFC Rules

• Controlled foreign corporation (CFC) rules are features of an income tax system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of an entity that is not currently taxed to the owners of the entity.

• Example: Subpart F Income

• U.S. shareholders of CFCs are NOW also subject to the new minimum tax on “global intangible low-taxed income” or GILTI on a current basis.

• Unlike subpart F, which is limited to certain categories of income, GILTI applies to essentially of all of a CFC’s income in excess of certain formula-based thresholds.

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GILTI Defined

• Section 951A adds GILTI as a new form of income included under Subpart F mechanics

▪ Each United States shareholder includes its pro rata share of GILTI, defined as the pro rata share of the aggregate “net tested income” of CFCs in excess of the “net deemed tangible asset return.”

▪ Net tested income equals all gross income of the CFC, minus allocable expenses, excluding the following: (1) subpart F income; (2) effectively connected income; (3) income excluded from subpart F by the high- taxed exception; (4) dividends received from a related person; and (5) foreign oil & gas extraction income.



More GILTI Basics

▪ The net deemed tangible income return equals 10% of the CFC’s qualified business asset investment (“QBAI”), minus the amount of the CFC’s interest expense allocated to reduce tested income.

▪ QBAI equals the tangible property of the CFC that is used in a trade or business and subject to an allowance for depreciation under Section 167 of the Code.

• In case of assets that produce both tested income and non-tested income, e.g., subpart F income, the QBAI is determined by making an allocation of basis between the two uses of the property.

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No Deferral with GILTI

▪ GILTI is subject to current taxation to U.S. Shareholder at ordinary rates as earned by the entity.

▪ Challenges with GILTI:

• Generally, no foreign tax credit is available to the individual shareholder for taxes imposed on the CFC (Section 962)

• No flow-through of losses or carryforward of losses is available

• No flow-through of capital gain character of income recognized by the CFC is available (i.e., all GILTI is ordinary income)



C-Corp Shareholders Results

• The GILTI rules are lenient in the context of a U.S. C corporation shareholder due to three considerations:

▪ Lowering of U.S. corporate rate from 35% to 21%

▪ 50% deduction (for years through 2025) for GILTI recognized by a U.S. C Corporation. See IRC Section 250(a).

▪ Indirect foreign tax credit for taxes imposed on GILTI under Section 960(d).

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GILTI Foreign Tax Credit Rules (New Section 960(d))

• An indirect credit is allowed for the foreign taxes imposed on the GILTI of a U.S. C Corporation’s CFCs. This follows the old indirect credit rules with important modifications:

▪ FTC is haircut by 20% of the total foreign taxes imposed on the GILTI (i.e., only 80% of taxes are allowed as an FTC).

▪ Old pooling rules of Section 902 are replaced by single year credit

▪ GILTI is a separate basket for Section 904(d) purposes

▪ No FTC carryover / carryback is permitted.



More GILTI

• Treatment as Subpart F Income. Except as otherwise provided in regulations, GILTI is generally treated as subpart F income for other purposes of the Code, including Sections 959, 961 and 962.

• Effective Date. GILTI applies to taxable years of CFCs beginning after Dec. 31, 2017.

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Summary: TCJA What changed? IRC 902 Repealed

Topic (Internal

Revenue Code)

2017 law What changed under TCJA

Foreign tax

credits/dividends

received (§ 902

repealed; § 245A

New)

Applies to domestic

corporation owning

10 percent or more

of the voting stock

of a foreign

corporation

Domestic corporation

received a credit for

income tax paid on

dividends received

from the foreign

corporation.

The domestic corporation now receives a 100-percent

deduction for the foreign-source portion of the dividends

received from the foreign corporation subject to a one

year holding period. The law allows no foreign tax credit or

deduction for any foreign taxes paid or accrued on the

qualifying dividend.

For more information, see IR-2018-235, IRS issues

proposed regulations on foreign tax credits.



Summary: TCJA What changed? 904 Amended

Topic (Internal

Revenue Code)


Income categories

(baskets) for

figuring foreign

tax credit

limitation (§ 904

Amended)

Foreign income is

designated passive

or general.

Separate income categories are allowed for non-

passive GILTI and foreign branch income. The law

defines “foreign branch income” as business profits of

a U.S. person attributable to qualified business units

(QBUs) in foreign countries. The law disallows any

carryover or carryback of foreign tax credits to or from

the GILTI income category.

For more information, see IR-2018-235, IRS issues

proposed regulations on foreign tax credits.

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https://www.irs.gov/newsroom/irs-issues-proposed-regulations-on-foreign-tax-credits






Summary TCJA What changed? IRC 960 Amended

Topic (Internal

Revenue Code)


Change to deemed-

paid credit for Subpart

F and GILTI inclusions

(§ 960 Amended)

Foreign-source income

earned by a foreign

subsidiary of a U.S.

corporation generally

isn’t subject to tax until

the subsidiary distributes

the income as a dividend

to the U.S. parent

corporation. However,

under the Subpart F

provisions certain

income is taxed currently

to the U.S. shareholder.

Deemed paid credits for

Subpart F inclusions and

previously taxed income

were computed

according to the § 902

formula that used

pooling concepts.

In place of the pooling regime, a “properly attributable to”

standard is used to compute deemed paid taxes with Subpart F

inclusions, foreign taxes on the distribution of previously taxed

income, and GILTI inclusions.

For more information, see IR-2018-235, IRS issues proposed

regulations on foreign tax credits.



Review Questions 2 & 3

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Thank You for Attending Today’s Program



Final Exam

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Final Maximizing Foreign Tax Credits