By Anthony Diosdi
The 2017 Tax Cut and Jobs Act significantly changed the way we plan cross-border transactions. Prior to the 2017 Tax Cut and Jobs Act, foreign tax credits were calculated using tax pools. After the enactment of the Tax Cuts and Jobs Act, the pools have been repealed and replaced with a single year indirect credit for the foreign income taxes “attributable to” the item of income under Internal Revenue Code Section 960(a).
History of Foreign Tax Credits
As a result of the United States taxing U.S. persons on their worldwide income, in 1918, Congress enacted the foreign tax credit system. Foreign tax credits were developed to prevent double taxation of foreign source income. A foreign tax credit is intended to allow a U.S. taxpayer to reduce the U.S. federal income tax on its foreign-source income by the foreign income taxes assessed on the same income. Foreign tax credits are not available on all foreign source income. For example, foreign tax credits are not under Internal Revenue Code Section 901(j) for taxes paid to countries with which the United States does not maintain diplomatic relations with in the anti-boycott provisions of Internal Revenue Code Section 908.
To be a permissible foreign tax credit, the foreign tax at issue 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.” The 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.” See IRC Section 901(b). Internal Revenue Code Section 901(a) also allows 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 elective on a year-by-year basis.
Internal Revenue Code Section 960, as amended by the 2017 Tax Cut and Jobs Act adopts a new “properly attributable to” standard to determine the amount of foreign taxes deemed paid by U.S. Shareholders of Controlled Foreign Corporation (“CFC”) with respect to certain income inclusions from the CFC, including amounts included in the U.S. Shareholder’s gross income under Internal Revenue Code Section 951(a). (Internal Revenue Code Section 951(a) introduced the new global intangible low-taxed income (“GILTI”) regime. GILTI was intended to impose a current year tax on income earned from intangible property which is subject to no or a low tax rate outside the United States). Effective for tax years beginning after 2017, the Tax Cut and Jobs Act repealed Section 902, which previously provided deemed-paid foreign tax credits with respect to actual and deemed dividends received from certain foreign corporations.
Internal Revenue Code Section 960(a) now provides that U.S. corporate shareholders that include “any item of income under Code Section 951(a)(1)” with respect to any CFC shall be deemed to have paid “so much of such foreign corporation’s foreign income taxes as are properly attributable to such item of income.” As a result, Internal Revenue Code 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 (GILTI), and Section 956 inclusions (Under Internal Revenue Code Section 956, a U.S. shareholder must include in his or her income his or her pro rata share of the CFC’s increase in its E&P invested in U.S. property for the taxable year). Claiming a foreign tax credit under Internal Revenue Code Section 960 has a price. Anyone claiming a foreign tax credit under Section 960 must gross up the inclusion by the amount of foreign taxes properly attributable to it pursuant to Internal Revenue Code Section 78.
The overall limitation limitation on a foreign tax credit can be expressed by the following formula:
U.S. Taxes on Worldwide Taxable Income X Foreign-Source Taxable Income
Income (before foreign tax credits)
Foreign Tax Credit Basket Limitations
Prior to the enactment of the 2017 Tax Cut and Jobs Act, special rules were built into the Internal Revenue Code which would allow taxpayers to average so-called tax pools in order to reduce the U.S. taxation of overall foreign source income. As discussed above, after the enactment of the Tax Cut and Jobs Act, the pools have been repealed and replaced with a single year indirect credit for foreign income taxes “attributable to” the item of income under the new Internal Revenue Code Section 960(a). Under this approach, different types of foreign source income are segregated for purposes of the credit.
Internal Revenue Code Section 904(d) was enacted to prevent foreign tax credits generated from high-taxed income to be used to offset U.S. taxation. Separate basket limitations are now provided under Section 904(d) to prevent foreign taxes paid on highly-taxed foreign income from being used to offset residual U.S. tax on low-taxed foreign income. Income categories in one basket cannot offset income in another basket. For tax years after 2017, there are specified baskets passive income, GILTI, foreign branch income, and one general, catchall basket for active business income.
For example, assume that a CFC wholly owns two foreign corporations that each generate foreign base company income. One foreign corporation is subject to foreign tax at an effective rate of 25 percent and the other foreign corporation is taxed at an effective rate of 15 percent. The CFC has a combined $160 of foreign source income. The CFC pays a total of $40 of foreign tax for a combined effective tax rate of 20 percent. Under the Internal Revenue Code prior to the enactment of the 2017 Tax Cut and Jobs Act, the CFC’s two wholly held foreign corporations foreign source income would be averaged for purposes of determining foreign tax credits. Under the new regulations of the 2017 Tax Cut and Jobs Act, the treatment of the foreign source income for foreign tax credit purposes would depend on the type of income earned by the CFC’s foreign corporations.
The Section 78 limitation formula discussed above is applied separately to each basket, and the results are combined for the total foreign tax credit for the year. For foreign tax credits applicable to the GILTI basket, there is an 80 percent limitation. Any amount includible in the gross income of a domestic foreign income taxes equal to 80 percent 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 the one immediately preceding taxable 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 (as determined applying the foreign tax credit separate limitation rules). GILTI credits are ineligible for a carryback or carryforward.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.