By Anthony Diosdi
Because the United States taxes U.S. persons on their worldwide income, the foreign tax credit was enacted in 1918 to prevent U.S. taxpayers from being taxed on their foreign-source income by both the foreign country where the income was earned and by the United States. The foreign tax credit is intended to allow a U.S. taxpayer to reduce the U.S. federal tax on its foreign-source income (but not U.S. source income) by the foreign taxes paid on that foreign income.
To be allowable under 26 U.S.C. Section 901(b), 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.” 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.
In addition, Internal Revenue Code Section 960, as amended by the 2017 Tax Cuts and Jobs Act, adopts a new “properly attributable to” standard to determine the amount of foreign taxes deemed paid by U.S. shareholders of CFCs with respect to certain income inclusions from CFCs including amounts included in the U.S. shareholder’s gross income under Section 951(a).
Internal Revenue Code Section 960 provides that U.S. corporate shareholders that include “any item of income under 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 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 attributable to it pursuant to Section 78.
To prevent the use of foreign tax credits to offset U.S. tax on U.S. income, Section 904 provides limitations. The overall limitation under Section 904(a) is expressed by the following formula:
Foreign-source taxable U.S. tax on Limitation
Income in relevant category x worldwide applicable
Worldwide taxable income income to category
Separate Basket Limitations
Congress decided to reduce the opportunities for cross-crediting excess foreign tax credits generated by foreign-source income subject to high foreign taxes against the U.S. tax otherwise imposed on low-taxed or tax-free foreign-source income. The method selected by Congress is to require the limitation of Section 904 be applied to separate categories (or “baskets” as they are often called) of foreign-source income. Foreign income eligible for a foreign tax credit must be allocated to one of the following baskets:
Passive Income Basket
The first category foreign income can be allocated is into the passive income basket.
The passive category income basket includes income that would be foreign personal holding company income under Section 954(c) if it were received by a controlled foreign corporation (“CFC”). See IRC Section 904(d)(2)(A). Because it incorporates by reference the Section 954(c) definition of foreign personal holding company income, passive income will generally include such items of income as dividends, interest, royalties, and rents. It also includes gains from the sale or exchange of property (other than inventory) that produces foreign personal holding company income or that produces no income. In addition, passive income includes certain foreign currency gains, gains from certain commodities transactions, certain income that is equivalent to interest, income from notional principal contracts and certain payments made in lieu of dividends.
GILTI Income Basket
The second category foreign income can be allocated is the GILTI basket. GILTI was enacted by the 2017 Tax Cuts and Jobs Act under Section 951A of the Internal Revenue Code. GILTI is a new anti-deferral provision that requires a deemed intangible income inclusion by U.S. shareholders of CFCs. 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 corporation under GILTI, such domestic corporation shall be deemed to have paid 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 the CFC.
General Limitation Basket
The third category of foreign income is a general catchall basket or general limitation basket for active business income. This basket is utilized to classify active foreign-source business income that is not GILTI income.
Foreign Branch Income
The final category is foreign branch income. The foreign branch category is for income attributable to foreign branches held directly or indirectly through a disregarded entity. The foreign branch category may also include a U.S. person’s share of partnership income that is attributable to a foreign branch held directly or indirectly by a foreign partnership. Foreign branch income may also include transactions between a foreign branch and the U.S. owner of the branch.
Any income that does not fall into the passive, GILTI, or foreign branch baskets automatically falls into the general category income limitation basket, which, therefore, can be thought of as a residual limitation basket. To apply the foreign tax credit basket limitation, the entity or individual seeking a foreign tax credit must take the following steps for each basket:
1. Determine the amount of gross income included in the basket;
2. Allocate and apportion deductions to the gross income to determine taxable income in the basket;
3. Identify all direct and indirect foreign tax credits attributable to that taxable income.
4. If necessary, apply the look-through rules of Section 904(d)(3) to interest, rents, royalties, dividends, and subpart F inclusions from CFCs;
5. Apply the rules for carryback of excess foreign tax credits.
In applying the above rules, foreign source income and applicable deduction must first be allocated to each appropriate basket. Next, the “look-through” rules of Section 904(d)(3) must be applied. Section 904(d)(3) provides a “look-through” rules for CFCs, allowing the U.S. corporate shareholders to be taxed on certain types of the CFCs earnings to be treated as taxable earnings.Under the Section 904(d)(3) look-through rules, if a U.S. shareholder includes in income actual dividends, constructive dividends under subpart F, interest, rents or royalties from a CFC, the appropriate limitation basket for the income is determined not with the reference to the character of the item of income itself (e.g., as a dividend, interest of royalty) but with reference to the underlying income of the CFC. To this extent, the CFC is treated, in effect, as a flow-through entity or a conduit for U.S. federal income tax purposes.
Finally, the carryback of excess foreign tax credits should be applied. Excess credit in any category other than GILTI is permitted to be carried back to the one immediately preceding the taxable year and carried forward to the first ten succeeding taxable years, and credited in such years to the extent that the U.S. entity or U.S. qualified individual has excess foreign tax credit limitations. However, excess GILTI credits may not be carried forward or backwards.
Special Rules for Allocation and Apportionment of Deduction in Calculation Limitations
As discussed above, in determining the foreign-source taxable income of a U.S. entity or person that falls within each separate limitation basket, deductions must be allocated and apportioned against the gross income falling within that basket. However, in connection with the allocation of interest deductions against foreign-source gross income in various baskets, in certain circumstances, the regulations under Section 864(e)(7)(C) require application of a special rule, sometimes called the “CFC netting rule.” See Treas. Reg. Section 1.861-10(e). The purpose of this rule is to discourage U.S. shareholders from borrowing funds and re-lending them to CFCs with the objective of improving the allocation and apportionment of interest expense for foreign tax credit limitation purposes over what would result if the CFC directly borrowed the funds. Under the regulations, if a U.S. shareholder has both a relatively large amount of loans to CFCs (“excess related group indebtedness”) and relatively large borrowings from third parties outside the affiliated group (“excess U.S. shareholder indebtedness”) in the tax year, it must allocate to its gross income in the various Section 904 foreign-source income baskets specified portions of the interest it pays to third-party lenders.
Under Section 904(d)(3) look-through rules, interest paid by a CFC to a U.S. shareholder or a related CFC may be subject to the special direct-allocation of interest rule discussed above. The existing rules for allocation of interest may be modified by a one-time election under Section 864(f) to a U.S. parent corporation. Under the Section 864(f) election, the foreign source taxable income of the U.S. member of an affiliated group is determined by allocating and apportioning interest expense of the U.S. member of an affiliated group on a worldwide basis. If the Section 864(f) election is made, the interest expense of the U.S. member will be equal to the excess of:
1. The worldwide affiliate group’s worldwide third-party interest expense multiplied by the ratio which foreign assets of the worldwide affiliated group bears to the total assets of the worldwide affiliated group, over
2. The third-party interest expense incurred by foreign members of the group to the extent such interest would be allocated to foreign sources if Section 864(f) were applied separately to the foreign members of the group.
For purposes of the elective rule, the worldwide affiliated group means all corporations in an affiliated group as well as all CFCs that, in the aggregate, either directly or indirectly, would be members of such an affiliated group.
Determining the exchange rate to determine for foreign taxes paid is extraordinarily complex. If your domestic corporation is attempting to claim a foreign tax credit, you should consult with an attorney well versed in international tax planning and compliance. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
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.