How to Calculate Foreign Tax Credit on Qualified Dividends


U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign income paid or accrued. The main purpose of the foreign tax credit is to mitigate the double taxation of foreign source income that might occur if such income is taxed by both the United States and a foreign country. Internal Revenue Code Section 901 limits the foreign tax credit to foreign taxes imposed on “income, war profits.” Internal Revenue Code Section 903 extends the credit to foreign taxes imposed “in-lieu-of” an income tax.
In order to be creditable under either Internal Revenue Code Section 901 or 903, a foreign levy must be a “tax.” A levy is a tax “if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes.” The tax also must be levied by the country pursuant to its taxing authority, not some other authority- as a result, penalties, fines, interest, and customs duties are not considered taxes. In addition, a foreign levy is not a tax to the extent the person subject to the levy receives a “specific economic benefit” from the foreign country in exchange for a payment. Only compulsory payments are considered payments of tax. A payment is not compulsory to the extent that the amount paid exceeds the amount of liability under foreign law for tax.
The calculation of a foreign tax credit is not a straightforward exercise. Often taxpayers have to take into consideration certain adjustments. Often taxpayers pay foreign taxes on qualified dividends. Taxpayers that pay foreign taxes on qualified dividends are required to adjust the credit under Section 904(b) of the Internal Revenue Code to calculate the rate difference. This article will discuss the adjustment that must be made for foreign tax credits on qualified dividends.
In order to understand how this credit adjustment is made, let’s assume that the taxpayer received $83,970 from a Swiss pension. Let’s also assume that the Swiss pension distribution qualifies as a qualified dividend which is taxed at 15 percent (capital gains rates) under the U.S.-Swiss tax treaty. The dividend is also taxed by Switzerland.
Where there is a capital gains rate differential (e.g., capital gains are taxed at lower rates than ordinary income), adjustments must be made to capital gains when calculating the numerator of the foreign tax credit limitation fraction. The adjustment is needed to take into account the difference between the maximum U.S. tax rate and the more favorable capital gains rates. See IRC Section 904(b)(2)(B); Treas. Reg. Sections 1.904(b)-1(d). Without these adjustments, the amount of pre-credit U.S. tax attributable to foreign source income would not be accurate.
An individual taxpayer with qualified dividend income for which the income tax rate of Section 1(h) applies must make a rate differential adjustment in a manner similar to the adjustments for capital gains. A taxpayer can elect out of the rate differential adjustment if, among other requirements, the amount of foreign source income is less than $20,000. See Treas. Reg. Section 1.904(b)-1(e). Because the income at issue is more than $20,000, the election is not available to our hypothetical taxpayer.
Under Treasury Regulation Section 1.904(b)-1(c)(1), foreign source capital gain net income must be reduced by the rate differential portion of the capital gain net income. To make the adjustment, the instructions to the Form 1116 directs taxpayers to “multiply your foreign source qualified dividends in each separate category by 0.4054 if the foreign source qualified dividends are taxed at a rate of 15% and by 0.5406 if they are taxed at a 20% rate.
Here, our hypothetical taxpayer was in the 15% capital gains rate category. As a result, .4054 is used. Total Swiss dividends were $83,970. The maximum foreign tax credit available in the U.S. is $83,970 x .4054 = $34,041 adjusted qualified dividend.
For individual taxpayers, Internal Revenue Code Section 904(d)(2)(F) directs that high-taxed income is, “any income which (but for this subparagraph) would be passive income if the sum of (i) the foreign income taxes paid or accrued by the taxpayer with respect to such income, and (ii) the foreign income taxes deemed paid by the taxpayer with respect to such income under Section 902 or 960, exceeds the highest rate of tax specified in Section 1 …multiplied by the amount of such income..” Thus effectively, if the foreign tax rate is less than the highest U.S. rate, the high tax kick out rules will not apply.
In this case, the highest tax rate under Internal Revenue Code Section 1 is 39.6% and the Swiss withholding rate is 35%. Because the U.S. rate is higher, the high tax kick out rules do not apply to our hypothetical taxpayer.
This result is not affected by the qualified dividend adjustment required under Internal Revenue Code Section 904(b). According Prop. Treas. Reg. Section 1.904-4(2)(c)(ii), “the determination of whether foreign-source passive income is high-taxed is made before taking into account any adjustments under Section 904(b).” As explained in the preamble to proposed regs (NPRM REG-134935-11):
Questions have arisen regarding the coordination of these rules with the capital gains adjustments under Section 904(b)… The proposed regulations of Section 1.904-4(c) clarify that the determination as to whether income is high-taxed is made before taking into account any adjustments under Section 904(b).. The Treasury Department and the IRS believe these ordering rules are consistent with the use in Section 904(d)(2)(F) of the highest statutory U.S. tax rate, rather than the taxpayer’s pre-credit effective U.S. tax rate, to determine whether income is high-taxed.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
