By Anthony Diosdi
In order to provide the Internal Revenue Service (“IRS”) with the information necessary to claim a foreign tax credit, a U.S. corporation claiming a foreign tax credit must attach Form 1118 otherwise known as “Foreign Tax Credit – Corporations,” to its tax return. This is the first of a series of articles designed to provide a basic overview of the Form 1118. This article is designed to supplement the instructions for the Form 1118 promulgated by the IRS.
Income Classification Lines a, b, and c
The Form 1118 begins by asking the preparer to compute a separate foreign tax credit for each category of foreign source income. The preparer must complete a separate Form 1118 for each separate category of income. In order to answer the question on line a, the preparer must select from six different categories foreign source income. The directions to Form 1118 assigns codes to each category of income. The category of income a preparer can select from when preparing Form 1118 are as follows:
Code Category of Income
951A Section 951A Category Income
FB Foreign Branch Category Income
PAS Passive Category Income
901J Section 901(j) income which is sanctioned country income
RBT Income re-sourced by treaty
GEN General Category Income
Below are the definitions for each category of foreign source income for line a.
Section 951A Category Income
Section 951A (GILTI inclusions) category income is any amount in gross income under Section 951A (other than passive category income).
Foreign Branch Category Income
Foreign branch income is defined under Section 904(d)(2)(j)(i) as the business profits of a US person which are attributable to one or more Qualified Business Units.
Passive Category Income
Passive income generally the following:
1) Any income received or accrued that would be foreign personal holding company income if the corporation were a CFC. This includes any gain on the sale or exchange of stock that is more than the amount treated as a dividend under Section 1248.
2) Any amount includible in gross income under Section 1293 (which relates to certain passive foreign investment companies (“PFICs”).
Section 901(j) Income
Section 901(j) income is income earned from a sanctioned country.
Income Re-Sourced by Treaty
If a sourcing rule in an applicable income tax treaty treats any US source income as foreign source, and the corporation elects to apply the treaty, the income will be treated as foreign source.
General Category Income
This category includes all income not described above.
Line b.
Line b states that if Code 901j is entered on line a, the country code for the sanctioned country using the two-letter code (list at IRS.gov/countrycodes) must be entered.
Line c.
Line c states that if Code RBT is entered, the preparer should enter the country code (see the list of country codes at IRS.gov/countrycodes).
Schedule A Income or (Loss) Before Adjustments
Column 1. EIN or Reference ID Number
Column one requests that the preparer provide the employer identification number (“EIN”) or a reference ID number for related persons or their qualified business units (or “QBU”) from or through which the corporation derived foreign source income and/or paid or accrued creditable foreign taxes.
Where gross income is derived from a related person (within the meaning of Section 267(b) or 707(b)), enter the EIN or reference ID number of such related person. (A shareholder and all persons related to the shareholder under Sections 267(b) or 707(b) are treated as one person). In the case of income derived from a QBU of the related person, enter the EIN or reference ID number of the QBU. Enter the EIN or reference ID number of related entities and their QBUs through which the corporation paid or accrued creditable foreign taxes, even if no income from these entities is reported on Schedule A. If gross income is received or derived from an entity other than a related person, an EIN or reference ID number is not required.
Column 2. Foreign Country or U.S. Possession
Column two requests that the preparer enter the two-letter code (from the list at IRS.gov/CountryCodes) for each foreign country and U.S. possession within which income is sourced and/or to which taxes were paid or accrued. For branches that are QBUs, the instructions to Form 1118 direct the preparer to use a single line to report the aggregate branches’ gross income and deductions. The preparer should report the aggregate totals on a per-country basis. In column 1, the preparer should enter “QBU” and enter the country code in column 2. These amounts should be reported on Form 1118 for foreign branch category income or passive category income.
Column 3 Inclusions Under Sections 951(a)(1) and 951A
3(a). Excluded Gross-Up
Column 3(a) asks that the preparer report all inclusions under Section 951(a)(1) (including amounts under Section 951(a)(1)(B), Section 964(e)(4), and Section 965, and Section 951A (before gross-up). See IRC Section 904(d)(3) and Look-Through Rules, earlier, for more information with respect to the separate category of such inclusions. (Section 904(d)(3) provides a “look-through” rule for CFCs, allowing the U.S. corporate shareholder to be taxed on certain types of the CFC’s earnings to treat such earnings as directly earned). Column 3(a) requires the preparer to disclose the portion of subpart F under Section 951(a) income and global intangible low-taxed income (“GILTI”) under Section 951A.
Column 3(a) also requires the preparer to disclose any accumulated earnings subject to the Section 965 transition tax. In addition, column 3(a) requires the preparer to disclose any inclusions under Internal Revenue Code Section 964(e)(4). Section 964(e)(4) is a new provision of the Internal Revenue Code. It was introduced as part of the 2017 Tax Cuts and Jobs Act. Under Section 964(e)(4)(A), the “foreign source portion” of any amount characterized as a dividend under Section 964(e)(1) is treated as subpart F income, is includible in the gross income of US shareholders of such CFC. Finally, column 3(a) requires the preparer to disclose any Section 904 “look-through” income. For this purpose, generally, dividends, interest, rents, and royalties received or accrued by a US taxpayer is passive category income. However, if these items are received or accrued by a 10 percent U.S. shareholder from a CFC, they may be assigned to other separate categories, or may be treated as passive category income under the look-through rules of Section 904(d)(3). Dividends include any amount included in gross income under Section 951(a)(1)(B). Look-through rules also apply to subpart F inclusions under Section 951(a)(1)(A) and GILTI inclusions under Section 951A(a) to the extent attributable to income of the CFC in the passive category.
Column 3(b). Gross-Up (Section 78)
In column 3(b), the preparer is required to disclose any taxes deemed paid by a domestic corporation with respect to inclusions under Section 951(a)(1) and Section 951A as gross-ups. For inclusions under Section 951(a)(1) with respect to pre-2018 foreign corporation tax years, the gross-up is equal to the foreign taxes deemed paid with respect to such inclusions as reported in Schedule F-1 of Form 1118. As a threshold matter, a CFC shareholder must gross up the inclusion by the amount of foreign taxes attributable to it pursuant to Section 78. This is expressed by the following formula:
U.S. Taxes on Worldwide Taxable X Foreign-Source Taxable Income
Income (before foreign tax credits) Worldwide Taxable Income
In column 3(b), include taxes deemed paid by a domestic corporation with respect to inclusions under Section 951(a)(1) and Section 951A as gross-up as provided under Section 78.
Column 4 Dividends
Column 4(a). Excluded Gross-Up
Under column 4(a), the preparer should report dividends (before gross-up) from sources outside the United States for the applicable separate category. This includes dividends eligible for the dividends received deduction under Section 245A. In general, dividends from a domestic corporation are U.S. source income, including dividends from a domestic corporation which has 80 percent or more of its gross income from sources outside the United States.
Column 4(b). Gross-Up (Section 78)
According to the instructions promulgated by the IRS, for column 4(b), the preparer should include taxes deemed paid by a domestic corporation under Section 902 on distributions in a pre-2018 foreign corporate tax year by certain foreign corporations in income as a dividend gross-up. The gross-up is equal to taxes deemed paid with respect to dividends reported on Schedule F-1.
The amount of foreign taxes deemed paid under Section 902 may be illustrated by example 1, which assumes a 35-percent U.S. corporate tax rate.
Example 1.
Simplex, a Delaware corporation, has a wholly owned subsidiary organized under the laws of Country X (X-Sub). In its first year of operation X-Sub earns $100,000 in Country X, pays a 30-percent Country X income tax of $30,000 and pays a dividend to Simplex of $70,000.
Step 1. Determine the amount of foreign taxes deemed paid by Simplex under Section 902(a). This is the portion of the foreign taxes paid by X-Sub which “the amount of such dividends determined without regard to Section 78) bears to such foreign corporation’s post-1986 undistributed earnings. Thus, the numerator is the actual amount of the dividend (not grossed up under Section 78 by the amount of foreign taxes deemed to be paid with respect to that dividend under Section 902(a)). The denominator is X-Sub’s post-1986 undistributed earnings ($100,000 less the Country X corporate tax ($30,000) attributable to those earnings).
Dividends_____________ X Country X tax = amount deemed paid
X-Sub post-1986 earnings
$70,000 X $30,000 = $30,000
$70,000
Step 2. Gross up the amount of the dividend of $70,000 by adding to it an amount equal to the $30,000 of taxes deemed paid under Section 902(a). This is the amount includible in the income of Simplex on which the tentative U.S. tax is based. This gross-up is needed to avoid giving Simplex both a deduction and a credit for the 30-percent Country X tax and to create congruence with the credit that would have been available if Simplex had operated its business through a branch in Country X.
amount on which U.S. tax
Dividend + Taxes deemed paid = before credit will be
(Step 1) computed
$70,000 + $30,000 = $100,000
Step 3. Compute the tentative U.S. tax on the grossed up amount (before credit).
$100,000 x 35% = $35,000 (U.S. tax on dividend before credit)
Step 4. Credit the Section 902(a) deemed paid amount against the U.S. tax on the grossed amount. The result is the net U.S. tax payable by Simplex.
U.S. tax on grossed-up amount $35,000
Less Section 902(a) deemed paid amount – 30,000
Net U.S. tax $5,000
See example pg. 336 Taxation of International Transactions, Charles H. Gustafson, Robert J. Peroni, Richard Crawford Pugh Thompson West (2006).
Column 5. Interest
On column 5, the preparer must enter interest received from foreign sources. This includes interest that consists predominantly of an active foreign business activity that is wholly or partially exempt from U.S. federal tax under Internal Revenue Code Section 861(a)(1)(A).
Column 6. Gross Rents, Royalties, and License Fees
On column 6, the preparer must enter the gross rents, royalties, and license fees. A preparer should disclose foreign income received from a CFC for the exploitation of any intangible property rights, such as rights to foreign patents, confidential knowhow, trade secrets, copyrights, trademarks and franchises. Typically, income disclosed on column 6 originates from five different situations:
1. The licensing of intangible property rights to an independent or affiliated licensee in consideration for continuing royalties;
2. The transfer of intangible property rights to an independent or affiliated transferee in exchange for royalty-like or fixed payments that are treated as capital gain;
3. The transfer of intangible property rights to a foreign corporation in exchange for its stock or as a contribution to capital;
4. The sharing of intangible property rights pursuant to a cost sharing arrangement under which related parties agree to share the cost and risks of developing intangible property in return for an interest in any intangible property created; and
5. The handling of international licensing of foreign intangible property rights through a foreign base company organized in a country having favorable legal and tax regimes.
The preparer should disclose all gross rents, royalties, and license fees received by the domestic corporation from outside the U.S.
Column 7. Sales
For column 7, the preparer must list any foreign source gross income from sales (net of return and allowances and less costs of goods sold). The preparer must include the foreign source portion of Section 863(b) sales in column 7. (Section 863 deals with categories of income that are partially U.S. and partially foreign-source).
Column 8. Gross Income
For column 8, the preparer must disclose any gross income received from outside the United States. This includes compensation, commission, fees, etc., for technical, managerial, engineering, construction, scientific, or similar services outside the United States.
Column 9. Section 986(c) Gain or Loses
Under column 9, the preparer must disclose any foreign source exchange gain recognized under section 986(c) on a distribution of previously taxed income or PTEP. Internal Revenue Code Section 986 contains the rules for translating foreign taxes and a foreign corporation’s earnings and profits into U.S. dollars and the regulations for Section 986(c) contains exceptions for inflationary currencies.
Column 10. Section 987 Gain or Loss
Under column 10, the preparer must list any foreign source exchange gain recognized under Section 987(3) on a remittance from a QBU. According to the directions to Form 1118, Section 987 prescribed the regime for dealing with a foreign branch that is a QBU using a foreign functional currency. Section 987 prescribes the regime for dealing with a foreign branch that is a QBU using a foreign functional currency. The basic approach should be to determine the profit or loss of the foreign branch for the tax year in its functional currency and then to translate the profit or loss at the “appropriate exchange rate.” The appropriate exchange rate is the average exchange rate for the tax year. See IRC Section 989(b)(4).
To determine the profit or loss of the branch, the branch preparer a profit and loss statement from the branch’s books and records, makes adjustments necessary to conform the statement to U.S. tax principles (called the “adjusted statement”) and translates the amount shown on the adjusted statement into U.S. dollars at the average exchange rate for the tax year. The branch must translate any amount shown on the adjusted statement attributed to dividends at the spot rate when the amount is included income.
When there is a remittance from the foreign branch to the U.S. parent entity (or another QBU having a different functional currency), the U.S. corporation recognizes gain or loss to the extent that the dollar value of the foreign currency at the time of its remittance differs from its dollar value when earned.
In regards to calculating gain or loss for purposes of Section 987, the regulations have yet to be issued to reflect changes to the tax law under the 2017 Tax Cuts and Jobs Act. Instead, the IRS issued Notice 2019-65 announcing that the Department of Treasury and the IRS intend to amend the regulations under Section 987 (concerning foreign currency gain or loss). In absence of an effective set of regulations, U.S. corporations can use a reasonable method that clearly reflects its income. One reasonable method could be to utilize the current regulation in place under Section 987.
Under the current regulations for calculating Section 987 gain or loss on remittance, the U.S. corporation must establish and maintain two pools for the branch: an equity pool and a basis pool. The equity pool is the domestic corporation’s investment in the branch maintained in the branch’s functional currency. The basis pool is the domestic corporation’s investment in the branch maintained in the domestic corporation’s functional currency. See Prop. Reg. Section 1.987-2(a)(1), (c).
The domestic corporation has Section 987 gain or loss on a remittance from the branch to the extent that the amount of the remittance translated into U.S. dollars at the spot rate on the date of the remittance exceeds or is less than the portion of the basis pool attributable to the remittance. The current regulations to Section 987 provide the following formula attributable for determining the portion of the basis poo, attributable to a remittance:
Amount of remittance
(in the branch’s basis pool reduced
Functional currency) x by prior
Equity pool balance remittance
Reduced by prior
remittance
See Prop. Reg Section 1.987-2(d)(2).
Below please find example 2 which discusses the calculation of the remittance of foreign currency under the soon to be withdrawn regulations.
Example 2.
DC, a U.S. corporation, has the U.S. dollar as its functional currency. It operates a branch in Country M, which has the ‘p” as its functional currency. During year 1, DC transfers 4,000p to the branch when 2p = $1. Also, in year 1, DC transfers $2,000 to the branch when 3p = $1. As a result of these transfers, the DC’s equity pool in the branch is 10,000p and its basis pool is $4,000. During year 1, the Country M branch has a profit of 10,000p, which is translated into U.S. dollars at the average exchange rate for year 1 of 2p = $1, i.e., $5,000. Thus, DC’s equity pool in the branch is increased to 20,000p and its basis pool is increased to $9,000. In year 1, the Country M branch remits 5,000p to DC’s home office when 2p = $1. DC has Section 987 gain to the extent the amount of remittance translated into U.S. dollars at the spot rate on the date of remittance ($2,5000) exceeds the portion of the basis pool that is attributable to the remittance under the above formula.
5,000p x $9,000 = $2,250
20,000p
Consequently, DC’s Section 987 gain is $250, and DC has a basis of $2,500 in the 5,000p remitted. At the end of year 1, DC’s equity pool is 15,000p (20,000p minus 5,000p remittance) and its basis pool is $6,750 ($9,000 minus $2,250 portion of that pool attributable to the remittance).
Despite the fact that the Department of Treasury and the IRS have yet to issue guidance on how to calculate gain or loss under Section 987, a domestic corporation must utilize a reasonable method to determine such a gain or loss for purposes of column 10. It is my opinion that the above discussed method is one potential method a domestic corporation may utilize to calculate gain or loss under Section 987.
Column 11. Section 988 Gain or Loss
Under column 11, the preparer must include any foreign source exchange gain recognized under Section 988. Section 988 exchange gain or loss is sourced by reference to the residence of the taxpayer or the QBU of the taxpayer on whose books the nonfunctional currency asset or liability is properly reflected. Transactions in a foreign currency of a taxpayer, other than a QBU using a foreign functional currency, must be transacted into dollars on a transaction-by-transaction basis. Most of these transactions in a business context are governed by Section 988 and are labeled “Section 988 transactions.” Section 988 transactions include four separate categories:
1. Acquisition of a debt instrument or becoming an obligor under a debt instrument (i.e., lending or borrowing a foreign currency).
2. Accrual of an item of gross income or expense that is received or paid later.
3. Entering into or acquiring a forward currency contract, futures contract or similar financial instrument.
4. Disposition of a nonfunctional currency.
“Foreign currency gain” is defined for purposes of Section 988 as “gain from a Section
988 transaction to the extent such gain does not exceed gain realized by reason of change in exchange rates on or after the booking date and before the payment date.” See Section 988(b)(1). “Foreign currency loss” is correspondingly defined in Section 988(b)(2). Thus, if the taxpayer has a loss on the overall Section 988 transaction, there is no foreign currency gain even if a favorable change in the exchange rates reduce the amount of the overall loss on the transaction.
Please see example 3 below discussing Section 988 currency gains and losses.
Example 3.
A U.S. corporation buys a pound sterling instrument for 100 pounds when one pound = $1.80. The cost and adjusted basis of the instrument are therefore $180.
If the instrument is sold for 200 pounds when one pound = $2, the corporation’s realized gain is $220 ($400 amount realized minus adjusted basis of $180). However, its foreign currency gain is measured by the difference between the exchange rates on the bookings and disposition dates and therefore equals $20, calculated by multiplying the $.20 difference in the exchange rates by the original price of the instrument in pound sterling (100 pounds).
If the instrument is sold for 200 pounds when one pound = $.90 i.e., at a price equal to $180, no gain or loss is realized and therefore there is no currency gain or loss.
If the instrument is sold for 200 pounds when one pound = $1.00, i.e., at a price equal to $200, the corporation has a realized gain of $20 on the transaction. However, there is no foreign currency gain because the gain was not realized by reason of changes in the exchange rates but in spite of them.
If the instrument is sold for 200 pounds when one pound = $.50 i.e., at the price equal to $100, there is a loss of $80 and all of it would be a foreign currency loss (because all of the loss is realized by reason of changes in the exchange rates).
Column 12. Other
Under column 12, the preparer should Include any other gross income from sources outside the United States for the applicable separate category. To properly complete column 12, the preparer should attach a schedule identifying the gross income by type.
Column 13.
To complete Column 13, the preparer must add columns 3(a) through 12.
Column 14. Allocable Deductions
Column 14(a). Dividends Received Deductions
Column 14a asks the preparer to enter dividends received deduction allowed on foreign source dividends under Section 245A. Internal Revenue Code Section 245A allowed a deduction for the amount equal to the foreign-source portion of such dividend. An example of how Section 245A operates can be analyzed under Section 1248. Under Internal Revenue Code Section 1248(a), gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividend income to the extent of the relevant earnings and profits accumulated while such person held the stock. After the enactment of the 2017 Tax Cuts and Jobs Act, this conversion of gain into a divided generally triggers an exemption pursuant to the Section 245A dividends received deduction. The preparer should disclose any Section 245A dividends under column 14(a).
Column 14(b). Deduction Allowed Under Section 250(a)(1)(A)- Foreign Derived Intangible Income
Column 14(b) asks the preparer to enter the deduction under Section 250(a)(1)(A) with respect to foreign derived intangible income, taking into account the other provisions of Section 250, that is allocated and apportioned to foreign source income in the applicable separate category of income. Under Internal Revenue Code Section 250(a)(1)(A) in the case of a domestic corporation for any taxable year, there shall be allowed as a deduction an amount equal to the sum of 37.5 percent of the foreign-derived intangible income of such domestic corporation. The preparer should disclose any deductions claimed under Section 250(a)(1)(A) under column 14(b).
Column 14(c). Deduction Allowed Under Section 250(a)(1)(B)- Global Intangible Low-Taxed Income
Column 14(c) asks the preparer to enter the deduction allowed under Section 250(a)(1)(B) with respect to GILTI (Section 951A inclusion), taking into account the other provisions of Section 250, that is allocated and apportioned to foreign source income in the applicable separate category of income. Under Internal Revenue Code Section 250(a)(1)(B) in the case of a domestic corporation for any taxable year, there shall be allowed as a deduction an amount equal to the sum of 50 percent of the global intangible low-taxed income amount (if any) which is included in the gross income of such domestic corporation under Section 951A for such taxable year. The preparer should disclose any deductions claimed under Section 250(a)(1)(B) under column 14(c).
Column 14(d). Depreciation, Depletion, and Amortization
Column 14(d) asks the preparer to enter the depreciation, depletion, and amortization deductions related to rental, royalty, and licensing expenses that are allocated and apportioned to foreign source income in the applicable category of income.
Column 14(e). Other Allocable Expenses
Column 14(e) asks the preparer to enter the allocable expenses related to rental, royalty, and licensing expenses that are allocated and apportioned to foreign source income in the applicable separate category of income.
Column 14(f). Expenses Allocable to Sales Income
Column 14(f) asks the preparer to enter the expenses allocable to gross income from sales that are allocated and apportioned to foreign source income in the applicable separate category of income (the amount entered in column 7 of this schedule).
Column 14(g). Expenses Allocable to Gross Income From Performance of Services
Column 14(g) asks the preparer to enter the gross income from performance of services that are allocated and apportioned to foreign source income in the applicable separate category of income (the amount entered in column 8 of this schedule).
Column 14(h). Other Allocable Deductions
Column 14(h) asks the preparer to enter the deductions allocable to income from sources outside the U.S. (dividends, interest, etc) for the applicable separate category that are not otherwise included in Schedule H. The preparer should include any reduction of foreign source capital gain net income. If foreign source capital gain net income from all separate categories is more than the capital gain net income reported on the corporation’s tax return, enter a pro rata portion of the excess as a negative number in each separate category.
Column 14(i). Apportioned Share of Deductions
Column 14(i) asks the preparer to add columns 14(a) through 14(h).
Column 15. Apportioned Share of Deductions
Column 15 asks the preparer to enter only the apportioned share from the applicable portion of line 3 (that correspondents to the category of income for which the corporation is completing Form 1118 of Schedule H, Part II, column (d), that relates to gross income reported in columns 3 through 12.
Column 16. Net Operating Loss
Column 16 asks the preparer to enter the corporation’s Net Operating Loss (“NOL”) permitted under Internal Revenue Code Section 172 that is attributable to foreign source income in the applicable separate category. The preparer should keep in mind the recent changes to the tax law governing NOLs. A key provision of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) involves Section 172(b)(1)which allows for a five-year carryback period for NOLs incurred for tax years beginning after December 31, 2017, but before January 1, 2021. This change potentially allows corporations to use NOLs generated in years with a 21 percent tax rate to offset taxable income from years that had a 35 percent tax rate.
Column 17. Total Deductions
Column 17 asks the preparer to add columns 14(i) through 16.
Column 18. Total Income or (Loss) Before Adjustments
Column 18 asks the preparer to subtract column 17 from column 13.
Conclusion
Completing Form 1118 for purposes of claiming foreign tax credits is extraordinarily complex. If your domestic corporation is attempting to claim foreign tax credits, 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: 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.