By Anthony Diosdi
The United States taxes U.S. persons on their worldwide income. In order to mitigate the consequence of worldwide taxation, the foreign tax credit rules were developed to prevent U.S. taxpayers from being double taxed. A foreign tax credit is intended to permit U.S. taxpayers to reduce the U.S. federal income tax on its foreign source income by the foreign income taxes paid on that foreign income. The foreign tax credit rules were also enacted to prevent U.S. taxpayers from utilizing foreign tax credits to offset domestic income. Foreign tax credits are not always permitted to offset federal tax liabilities. Foreign tax credits are denied under Internal Revenue Code Section 901(j) for taxes of certain countries with which the United States does not maintain diplomatic relations, and also under the anti-boycott provisions of Section 908. In addition, controlled foreign corporation (“CFC”) shareholders are sometimes not permitted to utilize foreign credits.
Internal Revenue Code Section 901(b) establishes the general rule as to when a foreign tax may qualify for foreign tax credit treatment. Under Section 901(b), to be allowable as a foreign tax credit, the foreign tax must be an “income, war profits (or) excess profits tax paid or accrued to any foreign country or to any possession of the United States.” Credit also is allowed under Section 903 for a “tax paid in lieu of a tax on income…otherwise generally imposed by any foreign country or by any possession of the United States.” Once it is determined that a foreign tax may qualify for foreign tax credit treatment, Internal Revenue Code Section 901(a) provides a “direct” credit or deduction against U.S. tax on foreign source income for foreign taxes directly paid or accrued by a U.S. person. The foreign tax credit provisions of the Internal Revenue Code are not automatic and an election to claim foreign tax credits is made on a year-by-year basis.
The Tax Cuts and Jobs Act revoked Internal Revenue Code Section 902. In the place of Section 902, Internal Revenue Code Section 960 enacted. Section 960 has adopted a new “properly attributable to” standard to determine the amount of foreign taxes deemed paid by U.S. shareholders for purposes of claiming the credit. As a threshold matter, Section 960(a) provides a basis for deemed-paid credits with respect to inclusions under Section 951(a)(1)(A) (subpart F inclusions), Section 951A (global intangible low-taxed income or “GILTI” inclusions), and Section 956 (investments in U.S. property inclusions). As part of the price of claiming the Section 960 foreign tax credit, a shareholder must gross up the inclusion by the amount of foreign taxes properly attributable to it pursuant to Internal Revenue Code Section 78.
To prevent the use of foreign tax credits to improperly reduce U.S. federal income tax on U.S. source income, Internal Revenue Code Section 904 provides various limitations on claiming foreign tax credits. Expressed foremulatically, the Section 904(a) limitations are determined as follows:
U.S. Taxes on Worldwide Taxable X Foreign-Source Taxable Income
Income (before foreign tax credits) Worldwide Taxable Income
In addition, Section 904(b) requires taxpayers to allocate each item of foreign source income into a basket. The calculation of available foreign tax credits that would reduce on a dollar-for-dollar basis the amount of U.S. tax owed, and the credibility of foreign taxes allocable to each Section 904(d) basket is subject to the Section 904(a) limitation with respect to the specific basket. There are specific baskets for passive income, GILTI, foreign branch income, general income, and active business income. The aforementioned limitation formula is applied separately to each basket and results in the total foreign tax credit for each year. Any excess foreign tax credits in one basket cannot generally be attributable to another basket. For example, any excess foreign taxes paid on GILTI income cannot generally be reallocated to the general basket.
There are also special limitations on GILTI foreign tax credits. For foreign tax credits applicable to the GILTI basket, there is an 80% limitation. Any amount includible in the gross income of a domestic corporation under GILTI, such domestic corporation shall be deemed to have paid foreign income taxes equal to 80% of the product of such domestic corporation’s inclusion percentage multiplied by the aggregate tested foreign income taxes paid or accrued by CFCs.
Excess credit in any category other than GILTI is permitted to be carried back to one immediate preceding year and carried forward to the first ten succeeding taxable years, and credited in such years to the extent that the taxpayer otherwise has excess foreign tax credit limitation for those years. GILTI credits are ineligible for a carry-back or carryforward.
Conclusion
Determining the amount of creditable foreign tax credits can be difficult. Through proper planning and techniques, it is possible to significantly reduce one’s exposure to GILTI, subpart F income, or other foreign source income. We have extensive experience advising multinational corporations and CFC shareholders in the area of foreign tax credit utilization.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi has substantial experience advising U.S. multinational corporations and other international tax practitioners plan for and calculate GILTI inclusions.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.