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Mastering Foreign Tax Credits for Corporations

and Individuals: Calculations, Carrybacks,

Carryforwards and Limitations WEDNESDAY, SEPTEMBER 7, 2016, 1:00-2:50 pm Eastern

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Sept. 7, 2016

Mastering Foreign Tax Credits for Corporations and Individuals

Morris N. Robinson, Esq., CPA, LL.M., Managing Director

M. Robinson & Co., Boston

[email protected]

Alison N. Dougherty, J.D., LL.M., Senior Manager

Aronson, Rockville, Md.

[email protected]

Patricia Weisgerber, Esq., LL.M.

M. Robinson & Co., Boston

[email protected]




Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

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RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Foreign Tax Credits:

General Overview

Attorney Morris N. Robinson, CPA. LLM

[email protected]

(c) M. Robinson & Company, Tax Law Specialists, September 2016. All

Rights Reserved.

Foreign Tax Credit Structure: General Overview

(c) M. Robinson & Company, Tax Law Specialists, September 2016.

All Rights Reserved. 6

Purpose of General Overview

1. To present the conceptual framework.

2. To provide, in conceptual format, a listing of relevant

sections of the Internal Revenue Code.




Objective of Foreign Tax Credit

1. Overall objective: Avoidance of double taxation by United

States and a foreign country on identical foreign source

income.

2. A Taxpayer may choose to take a deduction instead of a credit.

• IRC Sections 164 and 275(a)(4).




What Is Foreign Source Income?

Five Key Internal Revenue Code Sections

1. Income from United States Sources – Section 861

2. Income from Sources Outside the United States – Section 862

3. Sourcing of Income Not Included in Sections 861 and 862 – Section 863

4. Sourcing of Income from the Sale of Personal Property – Section 865

5. Income Re-sourced by Treaty Section – Section 904(d)(6)




Which Types of Foreign Source Income Are Creditable?

1. Realized Gross Income – Section 61

2. Certain Categories of Imputed Income

PFIC Inclusions – Section 1291(g)

PFIC Qualified Electing Funds – Section 1293(f)

Subpart F Income – Section 960

• Income reported under Sections 951 or 954




What Types of Foreign Taxes Are Creditable?

1. The foreign tax must tax income – Section 901

2. Check guidance from IRS and U.S. Treasury.

3. Foreign tax credit applies to taxes, not interest and/or penalties.




Who Can Claim the Credit?

The Taxpayer who reports the foreign source income claims the

credit. This includes the following:

1. Individuals

2. Partners in Partnership – Sections 702(a)(6) and 901(b)(5)

3. Shareholders of S Corporations – Section 1373(a)

4. Estates and Trusts/Beneficiaries – Sections 642(a) and 901(b)(5)

5. Recipient s of Income in Respect of Decedent – Section 691(b)





Continued…

6. Non-Resident Individuals – Sections 874(c) and 906

7. Foreign Organizations – Sections 882(c)(3) and 906

8. Exempt Organizations/Unrelated Business Income(UBTI) –

Section 515




Required Adjustment to the Foreign Tax Credit –

Exempt Income

1. Income of U.S. Citizens and Residents Living Abroad – Section

911(d)(6)Foreign Organizations – Sections 882(c)(3)

2. The foreign tax credit is NOT allowed on the portion of income

excluded under Section 911.

1. Why? Because, if income is excluded from United States

taxation, a double tax of that income by the United States

and a foreign country cannot occur.




Required Adjustment to the Foreign Tax Credit –

Corporations Only

1. Dividend Gross-Up – Section 78

Foreign taxes paid by a domestic parent corporation are

treated as additional dividends to the domestic parent.

2. Deemed Dividends from 10 Percent-Owned Foreign

Corporation – Sections 245 and 902

3. These gross-up rules only apply to corporations.




Related Parties – Suspension of Credit/Deduction

1. Generally, a Taxpayer may not deduct a foreign tax or claim a

foreign tax credit on foreign income taxes paid if a related

Taxpayer reports the income. See Section 909.

2. The regulations to Section 909 describe four types of

transactions involving related parties where the foreign tax

credit/deduction is suspended.




Substantiation

1. Foreign tax credits must be substantiated – Section 905(b)




Conversion of Foreign Taxes from Foreign Currency to

U.S. Currency

1. Generally, foreign taxes are converted at the spot exchange

rate at the time paid.

2. Generally, accrued foreign taxes may be converted at the

“average exchange rate” for the year – Section 986




Denial of Foreign Tax Credit – Certain Countries

1. Income taxes paid to certain countries are not creditable.

See Section 901(j) and Rev. Rul. 95-63.




Netting Capital Gains and Losses

1. Capital losses are netted against capital gains in computing the

foreign source capital gains and losses.




Redetermination of the Foreign Tax Credit

1. Reasons for Redeterminations – Section 905(c)

1. Tax Refunds

2. Additional Assessments

3. Late Payment of Accrued Foreign Taxes

2. Requirement to Notify the IRS – Section 905(c) and Treas. Reg.

1.905-3

3. Penalty for Failure to Notify the IRS: Up to 25% of Deficiency –

Section 6689




Statute of Limitations

1. Deficiency Arising from Foreign Tax Credit Carryback: One Year

– Section 6501(i)

2. The Statute of Limitations for Refunds Is Generally 10 Years –

Section 6511(d)(3)




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Rights Reserved.

Foreign Tax Credit Structure: Who Can Claim the Credit?



The General Rule

1. The Taxpayer that reports the foreign source income claims

the credit.

2. This is in keeping with the overall conceptual goal of avoiding

double taxation by the United States and a foreign

government on the identical foreign source income.

3. The application of these rules to various types of taxpayers

follows.




Individuals

1. Individuals may elect to take the foreign tax credit or may

deduct the foreign taxes.

2. There are special rules for taxpayers who are non-residents.

3. There are special rules for:

Partners in a partnership

S corporation shareholders

Beneficiaries of trusts and estates, and

Recipients of income in respect of decedent.

4. Some of these special rules are described below.




Resident Aliens

1. Resident aliens are treated like U.S. citizens.

See the above slide.

2. Resident aliens are treated like U.S. citizens with respect to

their foreign source income earned when they are residents of

the United States.

3. There are also special rules for individuals who are non-

resident aliens who have foreign source income that is subject

to United States income taxes.




Partners in Partnerships

1. Partnerships are not subject to tax. Section 701. The income of

a partnership is generally computed in the same manner as an

individual. Section 703.

2. Resident aliens are treated like U.S. citizens with respect to

their foreign source income earned when they are residents of

the United States.

3. There are also special rules for individuals who are non-

resident aliens who have foreign source income that is subject

to United States income taxes.




Partners in Partnerships

1. Partnerships are not subject to tax. Section 701. The income of

a partnership is generally computed in the same manner as an

individual. Section 703.

2. United States partners are subject to tax on their distributive

share of the partnership’s foreign income, which must be

separately listed on each partner’s Form 1065 K-1. Section

702(a)(6).




Partners in Partnerships cont.

3. Each partner’s “proportionate share” is allocated to him or her.

Section 901(b)(5).

4. These allocations must be consistent with:

1) The partnership agreement – Section 704(a)

2) The Treasury Regulations to Section 901(b)(5)

3) Economic reality – the partnership regulations.

Generally, the partner who receives the economic benefit from the foreign income

is allocated the foreign income earned by the partnership. The foreign income taxes

paid by the partnership and arising from the foreign income are allocated to the

partners.




S Corporations and Their Shareholders

1. S corporations are treated as partnerships; and

2. The shareholders of such corporation are treated as partners of

such partnership. Section 1373.

3. Partnerships are not subject to so-called “built-in gains.”

Therefore, foreign income taxes arising from the built in gains of

S corporations are not creditable.




Estates and Trusts/Beneficiaries

– Sections 642(a) and 901(b)(5)

1. The income of estates and trusts are generally subject to taxation

as if they were individuals, Section 641(b).

2. The United States incomes taxes arising from income earned by

estates and trusts (fiduciaries) are either taxed to the fiduciary or

to the beneficiary to whom the fiduciary’s income is distributed.




Estates and Trusts/Beneficiaries cont.

4. If the foreign income is not distributed, the fiduciary is subject to

tax on the foreign income.

The fiduciary may claim the foreign taxes paid by the fiduciary on

that income.

5. If the income is distributed to the beneficiary, the beneficiary is

subject to that foreign income.

6. For details, see Treasury Regulations to Section 901(b)(5).




Recipients of Income in Respect of Decedent

- Section 691(b)

1. “Income in Respect of Decedent” (“IRD”) is income that the

decedent should have reported as income had he or she survived

to receive it. Section 691(a)(1).

2. IRD has the same character in the hands of the recipient that it

would have had in the hands of the decedent. Section 691(a)(3).

3. The recipient may elect to deduct or credit the foreign taxes

associated with the foreign income of the decedent. Section

691(b).




Non-Resident Individuals – Sections 874(c) and 906

1. Non-resident individuals are subject to United States taxation on

income effectively connected with the conduct of a trade or business

within the geographical boundaries of the United States. Section 872.

2. Non-resident individuals are permitted to credit foreign income taxes

assessed against that income. Section 906.

3. Non-resident individuals are NOT permitted to credit foreign income

taxes assessed against “fixed, determinable, annual, or periodic”

income that is not effectively connected with the conduct of a

United States trade or business. Sections 874(c) and 906.




Foreign Corporations – Section 882(c)(3) and 906

1. A similar rule applies to foreign corporations. See the above

slide.




Exempt Organizations: Unrelated Business Income

– Section 515

1. Tax exempt organizations are subject to tax on their

unrelated business taxable income. Section 511.

2. If the unrelated taxable income of a tax exempt organization

includes foreign source income, these tax exempt

organizations can take advantage of the United States foreign

tax credit.

Foreign Tax Credits: Coordination with the Foreign Earned

Income Exclusion and the Foreign

Housing Exclusion Under Section 911


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Rights Reserved.

Foreign Tax Credit Structure: Coordination with Section 911



Coordination with Section 911

1. Foreign taxes are NOT creditable if allocable to foreign

income excluded under the foreign earned income credit or

the foreign housing allowance. Section 911(b)(6).

2. These non-creditable foreign taxes are disallowed on Form

1116, Part III, Line 12.

3. If only a portion for the foreign source income is excluded, a

proration of the foreign taxes is made.

See instructions to Form 1116, Part III, Line 12.


Special Rules for

Individuals and Corporations


[email protected]


Rights Reserved.

Foreign Tax Credit Structure: Special Rules for Individuals and Corporations



Individuals

1. Only individuals are entitled to the foreign earned income

exclusion and the foreign housing allowance.

2. Only individuals must adjust the amount of their creditable

foreign taxes by the taxes allocated to their foreign earned

income exclusion and their foreign housing allowance

exclusion.

3. The adjustment is made on Form 1116, Part III, Line 12.

Foreign Tax Credit Structure: Special Rules for Individuals and Corporations



Corporations

1. Only corporations are required to gross-up their dividends

(and deemed dividends) from the foreign corporations by the

foreign income taxes associated with those dividends.

2. These adjustments are reflected on Form 1118, Part A, Column

2 (Deemed Dividends) and Column 3 (Other Dividends).


A Closer Look at the Elements of the

FTC Calculation

Attorney Patricia Weisgerber, LLM

[email protected]


Rights Reserved.

Foreign Tax Credit: Elements of the FTC Calculation



Foreign Tax Credit Limitation Formula – Section 904

Max. FTC = U.S. Tax x Foreign Source Taxable Income

Worldwide Taxable Income The FTC limit is applied to each category of income.




Foreign Source Income

1. Income from Sources without the United States – Section 862(a)

1. Interest and dividends

2. Personal services compensation

3. Rents and royalties

4. Gains, profits and income

1. From the sale or exchange of real property

2. Derived from the purchase of inventory

5. Underwriting income

6. Amounts received from a foreign person for the provision of guarantee of

indebtedness




Foreign Source Income cont.

1. Gross income less expenses, losses and other apportioned or

allocated deductions – Section 862(b)

2. Special Rules for determining source of income – Section 863

1. Secretary to allocate source when not otherwise specified.

3. Sections 861 through 863 are not intended to be all inclusive

and the courts will determine source through comparison and

analogy.

1. Look to substance of transaction

2. Look at where transaction occurred




Foreign Source Income cont.

Controlled Foreign Corporation Subpart F Income – Section 952

1. Insurance income – Section 953

2. Foreign base company income – Section 954

3. Income subject to international boycott – Section 999

4. Illegal bribes, kickbacks and other payments – Section

952(a)(4)

5. Income derived from activities in sanctioned/901(j) countries




Creditable Taxes

1. Foreign Income Tax

2. Compulsory Payment

No Specific Economic Benefit

3. Tax on Income

Income

• Not VAT or GST

War Profits

Excess Profits

4. Paid or Accrued




Creditable Taxes

Predominant Character Test – Treas. Reg. 1.901-2(a)(1)(ii) and (3)(i)

1. Realization – Treas. Reg. 1.901-2(b)(2)

2. Gross receipts – Treas. Reg. 1.901-2(b)(3)

3. Net Income – Treas. Reg. 1.901-2(b)(4)

“likely to reach net gain”

PPL Corp. & Subsidiaries v. Commissioner, 135 T.C. 304 (2010) – U.K. windfall tax on excess profits

No “soak-up” or taxes designed to tax U.S. residents or citizens only to the extent each $1 of foreign tax reduces U.S. tax liability by $1 – Treas. Reg. 1.901-2(c)




Creditable Taxes

“In-Lieu-Of” Tax – Section 903

1. General income tax is not imposed, but in-lieu-of tax is imposed instead – Treas. Reg. 1.903-1(a)

Must act as a “substitute for” as opposed to an additional tax

2. In-Lieu-Of Tax Requirements:

Must be an income tax – See Treas. Reg. 1.901-2(a)(2)

Must meet the substitution requirements of Treas. Reg. 1.903-1(a)(1)

Must NOT be a “soak-up” tax




•Section 901 & 903

•Foreign Branches of Corporations

•Disregarded Entities

Directly Paid Foreign Taxes

•Sections 902 & 960

•Foreign Subsidiary of Corporation

•Sub-Part F Income

•Dividend Distributions

Indirectly Paid Foreign Taxes

Creditable Taxes




Creditable Taxes

Deemed Paid Tax – Sections 902 and 960

1. When a domestic corporation owns 10 percent or more of the voting stock of a foreign corporation from which it receives dividends – Section 902(a)

2. Amount of creditable tax is determined in proportion to the dividends received.

The dividend amount of dividends is without regard to the Section 78 “gross-up.”

3. Deemed paid or accrued.




Creditable Taxes - Section 78 Gross-up Example

Domestic corporations claiming the FTC under Sections 902 and 960 must gross-up the amount of the dividend received by the proportional amount of taxes deemed paid – See Treas. Reg. 1.960-3(a)

U.S. Corp.

CFC

$80 Dividend

CFC Profits before Tax $1,000

CFC Taxes $200

Post-1986 E & P $800 $80 (10%)

Post-1986 Taxes $200 $20 (10%)

Section 78 Grossed-up Dividend $100




The FTC Limit - Income Categories:

1. Passive Category Income – Section 904(d)(1)(A)

2. General Category Income – Section 904(d)(1)(B)

3. Section 901(j) Income

4. Income Re-sourced by Treaty

5. Lump Sum Distributions – Individuals Only

FTC Baskets



FTC Baskets

Passive

• Dividends

• Interest

• Rents

• Royalties

• Annuities

• Certain Net Gains

• Section 1293 Income

General

• Not Passive Category Income

•Active Business Income

•Wages

•Salaries

•Employee Overseas Allowances




FTC Baskets – Section 904

1. Prior to the American Jobs Creation Act of 2004, there had

been nine baskets of income.

2. Passive category income includes passive income and specified

passive income.

1. Specified passive income includes dividends from DISCs and

certain distributions from Foreign Sales Corporations.

3. General category income is income other than passive income

but includes certain types of income under the look-through

rules of Section 904(d).




Section 901(j) Income

1. Denial of FTC for countries the U.S. does not recognize, has severed diplomatic ties, does not conduct relations, or which provides support for acts of international terrorism.

2. No deduction either.

3. As of January 1, 1987 or 6 months from when a country is sanctioned.

4. Presidential waiver can permit credit.

5. See Revenue Ruling 2005-3.

1. Cuba removed as of December 21, 2015 per Rev. Rul. 2016-08.




Income Re-sourced by Treaty – Section 904

1. Purpose is to prevent taxpayers from inflating foreign tax

credit limitation by routing U.S. source income through a

foreign affiliate. Section 904(h).

2. Elect to apply the treaty so that the income will be treated as

foreign source. Section 904(d)(6).

3. Compute a separate FTC limitation for each amount of re-

sourced income from a treaty country.




Lump-sum Distributions

1. For taxes paid on a foreign source lump-sum distribution from

a pension plan.

For individual taxpayers only.

2. U.S. taxes are determined using Form 4972.

3. Special worksheet is provided in the instructions for Form 1116

to determine the amount of the credit.




Foreign Tax Credit Calculation – Example

Max. FTC = U.S. Tax x Foreign Source Taxable Income

Worldwide Taxable Income

$87.50= $350 x $250 $1000

The taxpayer’s final tax liability is $275.

U.S. Taxable Income $750

Foreign Source Income $250

Worldwide Taxable Income $1,000

U.S. Tax Liability (at a 35% tax rate (before the foreign tax credit) $350

Taxes levied by foreign country $75

(c) M. Robinson & Company, Tax Law Specialists, September 2016. All Rights Reserved.

59

Mastering Foreign Tax Credits:

Calculations, Carrybacks, Carryforwards and Limitations

Alison N. Dougherty September 7, 2016

http://blogs.aronsonllc.com/tax/u-s-taxpayers-foreign-tax-credits/

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Deduction vs. Credit for Foreign Taxes

1. A deduction for foreign tax paid or accrued is a

subtraction from income that decreases income that is

otherwise subject to U.S. Federal tax.

2. A credit for foreign tax paid or accrued is a dollar for

dollar offset against the U.S. Federal tax liability on the

foreign source taxable income.

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Deduction vs. Credit for Foreign Taxes - U.S. Individuals

Decision to claim deduction or credit applies to all qualified foreign taxes paid for a particular tax year

Cannot claim both a deduction and credit in the same year for foreign income taxes paid

Only foreign income taxes qualify for the foreign tax credit

Foreign taxes that are not income taxes such as foreign real and personal property taxes are deductible even if a credit is claimed for foreign income taxes

Deduct foreign taxes that are not income taxes only if they are trade or business expenses or related to production of income

Individuals claim Schedule A itemized deduction for foreign taxes paid if not trade or business expense or for production of income

Deduct foreign real property taxes as Schedule A itemized deduction if not trade or business expense or for production of income

Foreign tax credit is generally better than the deduction

Exception is when limitation prevents utilization of excess credits because there is not sufficient foreign source taxable income in carryback or carryforward years

No foreign tax credit allowed for foreign tax paid on income excluded based on foreign earned income exclusion including the foreign housing cost exclusion





Why should individuals choose the credit?

Foreign tax credit is a dollar for dollar reduction of U.S. Federal income tax liability on foreign source taxable income

Foreign tax credit is not allowed to offset U.S. Federal tax liability on U.S. source taxable income

Deduction of foreign tax only decreases income subject to U.S. Federal tax

The foreign income tax deduction for individuals is Schedule A itemized deduction

Individuals can choose to take the credit even if they do not claim Schedule A itemized deductions. The credit is allowed with the standard deduction.

With the credit, foreign tax that exceeds the limit are first carried back one year and then carried forward 10 years.

Individuals claim the foreign tax credit by filing Form 1116 with U.S. Federal Form 1040 individual income tax return.





Why should individuals choose the credit? IRS Publication 514 Example

For 2015, you and your spouse have adjusted gross income of $80,300,

including $20,000 of dividend income from foreign sources. None of the

dividends are qualified dividends. You file a joint return and can claim two

$4,000 exemptions. You had to pay $1,900 in foreign income taxes on the

dividend income. If you take the foreign taxes as an itemized deduction,

your total itemized deductions are $15,000. Your taxable income then is

$57,300 and your tax is $7,676.

If you take the credit instead, your itemized deductions are only $13,100.

Your taxable income then is $59,200 and your tax before the credit is

$7,961. After the credit, however, your tax is only $6,061. Therefore, your

tax is $1,615 lower ($7,676 − $6,061) by taking the credit.




Deduction vs. Credit for Foreign Taxes – U.S. Individuals

Making or changing the individual’s choice between foreign tax deduction or credit

Make or change the choice to claim a foreign tax deduction or credit at any time within 10 years from the original due date of the U.S. Federal Form 1040 individual income tax return (not including extensions) filed for the tax year in which the foreign tax was paid.

Make or change the choice on the U.S. Federal Form 1040 individual income tax return (or on an amended return) for the year the choice is to be effective.





IRS Publication 514 FTC for Individuals - Example of Individual making or changing choice (Part I)

You paid foreign taxes for the last 13 years and chose to deduct them on your U.S. income tax returns. You were timely in both filing your returns and paying your U.S. tax liability. In February 2015, you file an amended return for tax year 2004 choosing to take a credit for your 2004 foreign taxes because you now realize that the credit is more advantageous than the deduction for that year. Because the regular due date of your 2004 return was April 15, 2005, this choice is timely (within 10 years).





IRS Publication 514 FTC for Individuals - Example of Individual making or changing choice (Part II)

Because there is a limit on the credit for your 2004 foreign tax, you have unused 2004 foreign taxes. Ordinarily, you first carry back unused foreign taxes arising in 2004 to 2003, and claim them as a credit in, the preceding tax year. If you are unable to claim all of them in that year, you carry them forward to the 10 years following the year in which they arose.

Because you originally chose to deduct your foreign taxes and the 10 year period for changing the choice for 2003 has passed, you cannot change your choice and carry the unused 2004 foreign taxes back to tax year 2003.

Because the 10 year periods for changing the choice have not passed for your 2005 through 2014 income tax returns, you can still choose to claim the credit for those years and carry forward any unused 2004 foreign taxes. However, you must reduce the unused 2004 foreign taxes that you carry forward by the amount that would have been allowed as a carryback if you had timely carried back the foreign tax to tax year 2003.





Making or changing the choice for individuals

10 year limitations period applies for making election

Limitations period for refund claims relating to foreign tax

credit runs parallel with 10 year election period

Limitations period for refund claims relating to the foreign

tax deduction does not run parallel with 10 year election

period and it may expire before the end of the election

period.





10 year limitations period applies to claims for refund or credit

based on:

• Corrections for math errors in figuring qualified foreign

taxes

• Reporting qualified foreign taxes not originally reported on

the return, or

• Any other change in the amount of the credit (including

one caused by correcting the foreign tax credit limit).




Deduction vs. Credit for Foreign Taxes

CCA 201204008 – IRS allows change from deduction to

credit within 10 year period but change from credit to

deduction must be made within three year statute of

limitations period based on interpretation of I.R.C. Section

6511(d)(3).

CCAs 201330031 and 201517005 – IRS has followed its

conclusion and rejected refund claims based on change

from credit to deduction filed more than three years but

less than 10 years after original due date of original tax

return.




Deduction vs. Credit for Foreign Taxes – U.S. Corporations

U.S. corporation may choose annually whether to claim deduction or credit for foreign taxes paid or accrued.

If credit is claimed for the tax year then no portion of the foreign taxes will be allowed as a deduction in that year or any subsequent year.

Credit is claimed by filing Form 1118 with U.S. Federal Form 1120 corporate income tax return.

Deduction allowed for taxes ineligible for credit in the same tax year as credit for eligible taxes

Certain taxes are not eligible for deduction or credit





Foreign tax credit for U.S. corporations is a dollar for

dollar offset against regular U.S. Federal corporate income

tax liability

Separate corporate AMT foreign tax credit is allowed

subject to special AMT FTC limitation

Generally better to claim credit than deduction

Corporate foreign tax credit carryback one year and

carryforward 10 years





Examples of reasons why deduction would be preferable for

a corporation

When foreign source deductions exceed foreign source

income for the year

The limitation prevents utilization of excess credits when

foreign branch operations are discontinued and there is not

sufficient foreign source taxable income in first preceding

year or subsequent 10 years.




Limitations, Carrybacks, Carryovers and Recalculations

Terminology

Foreign tax credit limitation = the maximum amount of foreign tax credit that can be claimed in the current tax year

Excess limitation = limitation is greater than foreign tax credit that can be claimed

Excess credit = limitation is less than foreign taxes paid or accrued

Foreign loss = deductions properly allocated and apportioned to foreign source income exceed foreign source income

Domestic loss = deductions properly allocated and apportioned to U.S. source income exceed U.S. source income, determined without regard to loss carrybacks

Overall foreign loss (OFL) = the excess of foreign source loss over foreign source income that offsets U.S. source income

Overall domestic loss (ODL) = the excess of U.S. source loss over U.S. source income that offsets foreign source income

Separate limitation loss (SLL) = a loss arising in one separate limitation category

Separate limitation income (SLI) = foreign source taxable income computed for each income category as determined for the foreign tax credit limitation





I.R.C. Section 904 Foreign Tax Credit Limitation =

Foreign Source Taxable Income x U.S. Federal Tax

Worldwide Taxable income

Foreign tax credit allowed = the lesser of:

(1) the foreign taxes paid or accrued

(2) the amount of the foreign tax credit limitation





Foreign tax credit limitation example:

A is a U.S. citizen and has worldwide taxable income of

$75,000 for the current year of which $25,000 is from

foreign sources. A paid $10,000 of foreign tax on the

foreign-source income. A’s U.S. tax liability is $15,000

before the foreign tax credit. What is A’s foreign tax credit

limitation?

$25,000/$75,000 x $15,000 = $5,000





Foreign tax credit limitation is a function of the

proportionate amount of foreign source taxable income to

worldwide taxable income

Determine foreign source gross income based on U.S.

sourcing rules

Allocate and apportion expenses to foreign source income

Foreign source taxable income =

1. foreign source gross income less

2. directly allocable and indirectly apportioned expenses





To determine the foreign tax credit limitation, separate foreign source income into categories, i.e., baskets of income to prevent maximizing foreign tax credit by blending income subject to higher foreign tax rate with income subject to lower foreign tax rate.

Separate Limit Income - Must calculate the limit separately for each of the following categories of income. In figuring the separate limits, combine the income (and losses) in each category from all foreign sources and then apply the limit.

1. Passive category income including high taxed income

2. General category income

3. Section 901(j) income from activities in sanctioned countries

4. Certain income re-sourced by treaty

5. Any lump-sum distribution from an employer benefit plan for which the special averaging treatment is used to determine the tax

FTC limit = Foreign source taxable income in separate basket x U.S. Federal tax (before foreign tax credit) Worldwide taxable income





Foreign Losses - If there is a foreign loss when figuring your taxable income in a separate limit income category and there is

income in one or more of the other separate categories, first reduce the income in these other categories by the loss before

reducing income from U.S. sources. See IRS Publication 514.

The amount of your taxable income (or loss) in a separate category is determined after any adjustments you make to your

foreign source qualified dividends or your foreign source capital gains (losses).

Example – There is $10,000 of passive category income and a loss of $5,000 in the general category income basket. You must

use the $5,000 loss to offset $5,000 of passive category income.

How to allocate – You must allocate foreign losses among the separate limit income categories in the same proportion as each

category's income bears to total foreign source income.

Example – There is a $2,000 loss that is general category income, $3,000 of passive category income, and $2,000 of income

re-sourced by treaty. You must allocate the $2,000 loss to the income in the other separate categories. 60% ($3,000/$5,000) of

the $2,000 loss (or $1,200) reduces passive category income and 40% ($2,000/$5,000) or $800 reduces the income re-sourced

by treaty.

Loss more than foreign income - If you have a loss remaining after reducing the income in other separate limit categories,

use the remaining loss to reduce U.S. source income. For this purpose, the amount of your U.S. source income is your taxable

income from U.S. sources increased by the amount of capital losses from U.S. sources that reduced foreign source capital

gains as part of a U.S. capital loss adjustment. When you use a foreign loss to offset U.S. source income, you must recapture

the loss.

U.S. Losses - Allocate any net loss from sources in the United States among the different categories of foreign income after

allocating all foreign losses as described earlier, and before any adjustments.

The amount of your net loss from sources in the United States is equal to the excess of (1) your foreign source taxable income

in all of your separate categories in the aggregate, after taking into account any adjustments for qualified dividends and

adjustments to foreign source capital gains and losses over (2) the amount of taxable income you enter on Form 1116, line 18.





Recapture of Prior Year Overall Foreign Loss (OFL) Accounts

Overall foreign loss (OFL) - You have an overall foreign loss if your gross income from foreign

sources for a tax year is less than the sum of your expenses, losses, or other deductions that you

allocated and apportioned to foreign income under the rules explained.

If you have only losses in your separate limit categories, or if you have a loss remaining after allocating

your foreign losses to other separate categories, you have an overall foreign loss. If you use this loss to

offset U.S. source income (resulting in a reduction of your U.S. tax liability), you must recapture your

loss in each succeeding year in which you have taxable income from foreign sources in the same

separate limit category. You must recapture the overall loss regardless of whether you chose to claim

the foreign tax credit for the loss year.

You recapture the loss by treating part of your taxable income from foreign sources in a later year as

U.S. source income. In addition, if, in a later year, you sell or otherwise dispose of property used in your

foreign trade or business, you may have to recognize gain and treat it as U.S. source income, even if

the disposition would otherwise be nontaxable. The amount you treat as U.S. source income reduces

the foreign source income, and therefore reduces the foreign tax credit limit.

You must establish separate accounts for each type of foreign loss that you sustain. The balances in

these accounts are the overall foreign loss subject to recapture. Reduce these balances at the end of

each tax year by the loss that you recaptured. You must attach a statement to your Form 1116 or Form

1118 to report the balances (if any) in your overall foreign loss accounts. See IRS Publication 514.





OFL Recapture - If you have an overall foreign loss for any tax year and use the loss to offset U.S.

source income, part of your foreign source taxable income (in the same separate limit category as the

loss) for each succeeding year is treated as U.S. source taxable income. The part that is treated as

U.S. source taxable income is the smaller of the following.

1. The total amount of maximum potential recapture in all overall foreign loss accounts. The maximum

potential recapture in any account for a category is the lesser of:

a. The current year taxable income from foreign sources in that category (the amount from Form

1116, line 15, less any adjustment for allocation of foreign losses and U.S. losses for that category,

discussed earlier); or

b. The balance in the overall foreign loss account for that category.

2. 50% (or more, if you choose) of your total taxable income from foreign sources.

Deduction for foreign taxes - You must recapture part (or all, if applicable) of an overall foreign loss in

tax years in which you deduct, rather than credit, your foreign taxes. You recapture the lesser of:

1. The balance in the applicable overall foreign loss account, or

2. The foreign source taxable income of the same separate limit category that resulted in the overall

foreign loss minus the foreign taxes imposed on that income. See IRS Publication 514.





Recapture of Separate Limitation Loss Accounts - If in a prior tax year, you

reduced your foreign taxable income in the separate limit category by a pro rata

share of a loss from another category, you must recharacterize in the current year

all or part of any income you receive in the current year in that loss category. If you

have separate limitation loss accounts in the loss category relating to more than

one other category and the total balances in those loss accounts exceed the

income you receive in the current year in the loss category, then income in the loss

category is recharacterized as income in those other categories in proportion to

the balances of the separate limitation loss accounts for those other categories.

You recharacterize the income by:

1. Increasing foreign taxable income (adjusted by certain adjustments) for each of the

separate categories (other than the loss category) previously reduced by any

separate limitation loss, and

2. Decreasing foreign taxable income (adjusted by certain adjustments) for the loss

category by the amount of recharacterized income. See IRS Publication 514.





Recapture of Overall Domestic Loss Accounts - If you have an overall domestic loss for

any tax year beginning after 2006, you create, or increase the balance in, an overall

domestic loss account and you must recharacterize a portion of your U.S. source taxable

income as foreign source taxable income in succeeding years for purposes of the foreign

tax credit.

The part that is treated as foreign source taxable income for the tax year is the smaller of:

1. The total balance in your overall domestic loss account in each separate category (less

amounts recaptured in earlier years), or

2. 50% of your U.S. source taxable income for the tax year.

You must establish and maintain separate overall domestic loss accounts for each separate

category in which foreign source income is offset by the domestic loss. The balance in each

overall domestic loss account is the amount of the overall domestic loss subject to

recapture. The recharacterized income is allocated among and increases foreign source

income in separate categories in proportion to the balances of the overall domestic loss

accounts for those separate categories. See IRS Publication 514.





U.S. Treas. Reg. Section 1.904(g)-3 Ordering Rules

1. Allocate net operating losses and net capital loss

carryovers

2. Make I.R.C. Section 904(b) adjustments

3. Allocate separate limitation losses

4. Allocate U.S. source losses

5. Recapture overall foreign losses

6. Recapture separate limitation losses

7. Recapture overall domestic losses





Carryback and Carryover - If because of the limit on the credit, you cannot use

the full amount of qualified foreign taxes paid or accrued in the tax year, you are

allowed a 1-year carryback (not elective) and then a 10-year carryover of the

unused foreign taxes.

• This means that you treat the unused foreign tax of a tax year as though the tax

were paid or accrued in your first preceding and 10 succeeding tax years up to the

amount of any excess limit in those years. A period of less than 12 months for

which you make a return is considered a tax year.

• The unused foreign tax in each category is the amount by which the qualified taxes

paid or accrued are more than the limit for that category. The excess limit in each

category is the amount by which the limit is more than the qualified taxes paid or

accrued for that category.

• Figure your carrybacks or carryovers separately for each separate limit income

category. See IRS Publication 514.





Foreign Tax Redeterminations

Must amend U.S. Federal income tax return if you claim a

foreign tax credit and then receive a refund of the credited

taxes in a later year

Must reduce the credited taxes by the amount refunded

Penalties apply for the failure to amend to adjust





Foreign Tax Redetermination - A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed.

The year in which to claim the credit remains the year to which the foreign taxes paid or accrued relate, even if the change in foreign tax liability occurs in a later year.

If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required if any of the following conditions apply.

1. The accrued taxes when paid differ from the amounts claimed as a credit.

2. The accrued taxes you claimed as a credit in one tax year are not paid within 2 years after the end of that tax year.

If this applies to you, you must reduce the credit previously claimed by the amount of the unpaid taxes. You will not be allowed a credit for the unpaid taxes until you pay them. When you pay the accrued taxes, a new foreign tax redetermination occurs and you must translate the taxes into U.S. dollars using the exchange rate as of the date they were paid. The foreign tax credit is allowed for the year to which the foreign tax relates.

3. The foreign taxes you paid are refunded in whole or in part.

For taxes taken into account when accrued but translated into dollars on the date of payment, the dollar value of the accrued tax differs from the dollar value of the tax paid because of fluctuations in the exchange rate between the date of accrual and the date of payment. However, no redetermination is required if the change in foreign tax liability for each foreign country is solely attributable to exchange rate fluctuations and is less than the smaller of:

1. $10,000, or

2. 2% of the total dollar amount of the foreign tax initially accrued for that foreign country for the U.S. tax year.

In this case, you must adjust your U.S. tax in the tax year in which the accrued foreign taxes are paid. See IRS Publication 514.




ALISON N. DOUGHERTY

SENIOR MANAGER ARONSON LLC

Direct (301) 231-6290

Main (301) 231-6200

Email: [email protected]

805 King Farm Blvd, Third Floor

Rockville, MD 20850

Washington, DC Metro Area

Alison N. Dougherty provides tax services as a Senior Manager at Aronson

LLC. Alison specializes in international tax reporting, compliance,

consulting, planning and structuring as a subject matter leader of Aronson’s

international tax practice. She has extensive experience assisting clients

with U.S. tax reporting and compliance for offshore assets and foreign

accounts. She provides outbound U.S. international tax guidance to U.S.

individuals and businesses with activities in other countries. She also

provides inbound U.S. international tax guidance to nonresident individuals

and businesses with activities in the United States. She has worked

extensively in the area of U.S. international tax reporting and compliance

with the preparation of the U.S. Federal Forms 5471, 926, 8865, 8858,

5472, 1042, 1042-S, 8621, 8804, 8805, 8813, 8288, 8288-A, 8288-B, 1116,

1118, 1120-F, 1040-NR, 3520, 3520-A, 2555, 5713, 8832, 8833, 8840,

8843, 8854, 8938 and FBAR. She has counseled U.S. taxpayers regarding

the outbound formation, capitalization, acquisition, operation, reorganization

and liquidation of foreign companies. She has significant experience with

U.S. Federal nonresident tax withholding, foreign partner tax withholding

and FIRPTA withholding. She works closely with nonresident individuals

and businesses regarding inbound U.S. real property investment. She often

assists U.S. taxpayers with IRS amnesty program disclosures of offshore

assets and foreign accounts.

Alison completed the LL.M. (Master of Laws) in Securities and Financial

Regulation in 2004 with academic distinction at Georgetown University Law

Center. She completed the LL.M. (Master of Laws) in Taxation in 2000 and

the Juris Doctor in 1999 at the University of Denver College of Law. She

completed a Bachelor of Arts degree in Foreign Language in 1995 at

Virginia Commonwealth University.





Form 1116: Foreign Tax Credits for

Individuals, Estates and Trusts


[email protected]


Rights Reserved.

Foreign Tax Credits: Form 1116






Separate Categories of Income – The Five Boxes (a through e)

1. A separate Form 1116 is prepared for the Five Boxes:

1) Passive category income

2) General category income

3) Section 901(j) income

4) Income resourced by treaty

5) Lump-sum distributions from pension plans




Additional Forms 1116

1. Alternative Minimum Taxable Income.

For the Five Boxes, see the above slide.

2. PFIC Income. separate Form 1116 is prepared for the Five Boxes:

For the Five Boxes, see the above slide.




Part I: Foreign Source Income

1. Part I, Line g: Foreign source income is listed by country where

earned.

2. Part I, Line 2: Definitely related expenses.

3. Part I, Line 3: Prorated Expenses.

4. Part I, Line 3b: Prorated Itemized deductions.




Part I: Foreign Taxes Paid or Accrued

1. Election box: Paid or Accrued

2. Date paid or accrued

3. Allocation of tax to type of income

a. In foreign currency: columns (k), (l), (m), and (n)

b. In United States dollars: columns (o), (p), (q), and (r)




Creditable Taxes

1. Part III, Line 9: Taxes paid or accrued for the year.

2. Part III, Line 10: Carryback or carryforward of creditable foreign

taxes to the year.

3. Part III, Line 12: Reduction in Foreign Taxes associated with

foreign income excluded under Section 911.

• See earlier slide “Individuals”




Computation of the Maximum Allowable Credit

1. Part III, Lines 15-21: Computation of the maximum allowable

credit – per foreign income category.

See previous slides related to foreign income.




Total Credit

1. Part IV, Line 27: The total credit that can be claimed in any

taxable year.

2. Part IV, Lines 28-31: Special adjustments – see instructions to

Form 1116.


Form 1118:

Foreign Tax Credits for Corporations


[email protected]


Rights Reserved.







Part I: Foreign Source Income

1. Schedule A – Column 1: Foreign source income is listed by country where

earned.

2. Schedule A – Column 2: Deemed Dividends and Gross-Up

3. Schedule A – Column 3: Other Dividends and Gross-Up

4. Schedule A – Columns 4 through 7: Foreign interest, rent, services income

and other income.

5. Schedule A – Column 9: Definitively Allocable Expenses, by type of income

6. Schedule A – Column 10: Prorated expenses

7. Schedule A – Column 11: Net operating loss deduction arising from foreign

income.




Foreign Taxes Paid or Accrued

1. Schedule B – Column 1: Election Box: Paid or Accrued

2. Schedule B – Column 2: Foreign Taxes Paid or Accrued, listed by

types of income: (a) through (f)




Form 1118, Part II – Total Foreign Taxes Available for the

Foreign Tax Credit

1. Prepare a separate Form 1118, Part II for each category of foreign

tax. See the above slide.

2. Creditable taxes include:

1. Total Taxes Paid or Accrued – Part II, line 1a.

2. Suspended Foreign Taxes – Part II, line b. See earlier slide on

suspension of credits and deductions.

3. “Deemed Paid” Foreign Taxes – Part II, line 3. See earlier slide on

required adjustments.

4. Foreign Tax Credit Carryovers – Part II, line 5.




Computation of Maximum Allowable Credit

1. The computation of the maximum allowable credit: Part II, Lines 7

through 12.

2. The limitation is computed for each category of income.

3. The allowable foreign tax credits for each category of income are

summarized on Form 1118, Part III.


Tax Planning for

the Foreign Tax Credit


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Rights Reserved.

Foreign Tax Credits: Tax Planning



Planning for Foreign Source Income

1. The FTC is limited to the United States taxes associated with

foreign source income. See earlier slide on categories of

income.

2. To use up a FTC carryforward, create foreign source income of

the same category.




Planning for Foreign Source Income - Example

1. Foreign Tax Credit carryforward arises from foreign taxes on business

income.

General category income.

2. Taxpayer is selling tangible personal property FOB Port of Boston. The

income is U.S. source income.

See Section 861(a)(6) regarding inventory.

3. Change business terms to FOB foreign port.

Caution: This change in terms may affect the taxpayer’s

responsibility to insure the tangible personal property until it

arrives in the foreign port.




Planning for the Timing of the United States and

Foreign Income Tax Assessments

1. Foreign taxes can be carried back one year and carried forward

for 10 years.

2. If a foreign tax is assessed in 2016 and the United States tax on

foreign source income is assessed in 2019, the foreign tax credit

carryforward can eliminate foreign taxation.




Foreign Tax Credit Planning for Timing - Example

Installment Sale of Real Property Located in a Foreign Country

1. For foreign tax purposes, the foreign taxes are assessed

immediately following the year of sale; and the tax due is typically

due within a few months of year end.

2. For United States purposes, the income is reported under the

installment method as the proceeds of the sale are received.

3. The foreign tax credit carryforward allows the offset of foreign

taxes against income arising from the recognition of installment

income.




Planning the Timing of Tax Assessments (continued)

1. Foreign tax credit is NOT allowed if the United States tax is

assessed more than one year before the foreign tax is paid or

accrued.

Example: $1 million contribution is made to a foreign pension

plan that is NOT a qualified pension plan for United States

purposes. The year of contribution is 2016 and the year of

distribution is 2020.




Planning the Timing of Tax Assessments (continued)

Example

1. For United States income tax purposes, the contribution is reported as income in the

year of contribution., that is, in 2016. Section 402(b)(1).

2. For foreign income tax purposes, the contribution might not be subject to tax until

the income from the foreign pension plan is distributed to the taxpayer, that is, in

2020.

3. But the foreign taxes paid or accrued in 2020 cannot be carried back to 2016.

4. Discuss with the foreign tax advisors. Consider accelerating the foreign income –

perhaps by having the foreign employer pay the income to the United States

employee who then contributes the money to a qualified annuity plan.

5. “Plan B” – if necessary, deduct the foreign taxes.

(c) M. Robinson & Company, Tax Law Specialists, September 2016. All Rights Reserved.

111

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