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 second 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.
Introduction to Schedule B
Schedule B is utilized to report foreign taxes paid, accrued, or deemed paid for the taxable year. All transactions on Schedule B must be reported in U.S. dollars. If the corporation must convert from foreign currency, attach a schedule showing the amounts in foreign currency and exchange rate used. If foreign currency must be converted in order to complete Schedule B, the preparer must attach a schedule stating the exchange rate used.
If the corporation is on the accrual method of accounting, the exchange rate for translating foreign taxes into U.S. dollars will generally be an average exchange rate for the tax year to which the taxes relate. However, the spot rate of exchange (a spot exchange rate is the currency price level in the market to directly exchange one currency for another, for delivery on the earliest possible value date) must be used if the foreign taxes (a) are paid more than two years after the close of the tax year to which they relate, or b) are foreign taxes paid in a tax year prior to which they relate. Finally, corporations may elect to use the exchange rate on the date of payment of the foreign tax. Corporations may elect to use the payment date exchange rates for all creditable foreign income taxes or only those taxes that are attributable to “qualified business units” (“QBUs”) that use the U.S. dollar as functional currency.
Column 1. Credit Claimed for Taxes
Column 1 is utilized to select the method a credit is claimed for foreign tax credit. A corporation can use either the cash or accrual method of accounting. If the corporation reports its income and expenses as a cash basis taxpayer, it may still report its foreign tax expenses under the accrual method. However, the corporation must make an election under Internal Revenue Code Section 905.
In column 1, the corporation will list the dates the foreign taxes were either paid or accrued.
Column 2. Foreign Taxes Paid or Accrued
For column 2, the corporation must attach a schedule showing the applicable conversion rates utilized to convert foreign currency.
Column 2(a) Dividends
For column 2(a), the corporation must list any dividends associated with foreign taxes paid. The corporation must include foreign taxes withheld at sources on dividends from a first-tier foreign corporation. Corporations must consider Internal Revenue Code Section 245A when completing Column 2(a). Section 245A allows an exemption for certain foreign income of a domestic corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction (“DRD”) for the foreign-source portion of dividends received from “specified 10-percent owned foreign corporations” by certain domestic corporations that are U.S. shareholders of those foreign corporations within the meaning of Section 951(b). (The term “specified 10 percent foreign corporation” is defined as any foreign corporation with respect to which any domestic corporation owns at least 10 percent). Effective for distributions made after December 31, 2017, Section 245A(a) allows C corporations that are U.S. shareholders a deduction equal to the foreign-source portion of a dividend received from a specified 10 percent foreign corporation. Any eligible Section 245A dividends should also be disclosed under column 2(a).
Column 2(b) Distributions of Previously Tax Income
For column 2(b), the corporation must list the foreign taxes withheld at the source of previously taxed earnings and profits (“PTEP”) distributions from a first-tier foreign corporation. However, the corporation should not list any foreign taxes withheld at the source on PTEP distributions from a lower-tier foreign corporation to an upper-tier foreign corporation and then deemed paid by the domestic corporation under Section 960(a)(3) (pre-2018 foreign corporate tax years) or 960(b) (post-2017 foreign corporate tax years) on a distribution from the upper-tier foreign corporation to the domestic corporation. Instead, these amounts are stated on Schedule E.
It should be noted that the PTEP regime also requires upward and downward basis adjustments in CFC stock for gross income inclusions at the U.S. shareholder level attributable to such CFC. In the event a U.S. corporation owns multiple CFCs through a tiered chain of ownership, the PTEP regime basis adjustment rules generally provide that all adjustments occur in the CFC stock owned directly by the U.S. corporation.
Column 2(c) Branch Remittances
For column 2(c), the corporation must include foreign taxes withheld on branch distributions or transfers as determined under Internal Revenue Code Section 987. Section 987 prescribed the regime for dealing with a foreign branch that is a QBU using a foreign functional currency. The basic approach is to determine 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.” See IRC Section 987. The appropriate exchange rate is the average exchange rate for the tax year. See IRC Section 989(b)(4).
When a corporation and branch uses the accrual method to account for foreign taxes for purposes of the foreign tax credit, the average exchange rate for the tax year to which it relates should be used. See IRC Section 986(a)(1)(A). This rule does not apply to: 1) any foreign income taxes paid more two years after the close of the tax year to which the taxes relate; 2) any foreign income taxes paid before the start of the tax year to which the taxes relate; or 3) any foreign income taxes the liability for which is denominated in any inflationary currency. See IRC Section 986(a)(1)(B), (C). This rule also does not apply to corporations and branches that use the cash method to account for foreign taxes.
If the foreign income tax paid differs from the amount of foreign tax accrued or if the foreign income tax is fully or partially refunded, the corporation must notify the IRS. See IRC Section 905(c)(1)(A), (C). Redetermined foreign taxes paid are generally translated into U.S. dollars using the exchange rate applicable on the date the foreign tax adjusted is paid to the foreign country. See IRC Section 986(a)(2)(B)(i). If foreign taxes are refunded or credited to the corporation by a foreign country, the redetermination amount of taxes paid or translated into U.S. dollars using the exchange rate as of the date of the original payment of taxes. See IRC Section 986(a)(2)(B)(ii). In the case of a direct foreign tax credit, accrued foreign income taxes paid more than two years after the close of the tax year to which the taxes relate are taken into account for the tax year to which the taxes relate, but are translated using the exchange rates in effect as of the time of payment of the taxes. Please see the example below.
Example
DC, a domestic corporation that uses the accrual method for foreign tax credit purposes, accrues in year 1 100 units of foreign tax owing to Country Y. Country Y’s currency is not inflationary. The year 1 Country Y foreign tax is unpaid at the end of the year 1. DC does not make an election under Section 986(a)(1)(D). Under Section 986(a)(1), DC translates the 100 units of Country Y foreign tax into U.S. dollars using the average exchange rate for year 1. If DC pays the 100 units of Country Y foreign tax in year 2 or year 3, DC is not required to redetermine its foreign tax for year 1 even if the dollar value of the foreign tax paid differs from the accrued amount due to the foreign currency fluctuations. If, however, any portion of the accrued Country Y tax for year 1 remains unpaid as of the end of year 3, DC must redetermine its accrued foreign tax under Section 905(c) for year 1 to eliminate the accrued but unpaid Country Y tax and reduce its foreign tax credit. If DC pays the disallowed tax in year 4, DC must again redetermine its Country Y foreign tax and foreign tax credit for year 1, but the year 1 tax paid by DC in year 4 is translated into U.S. dollars using the exchange rate in effect for the date of payment in year 4. See H.R. Conf. No. 220, 105th Cong., 1st Sess. 614-15 (1997).
Column 2(d) Interest
For column 2(d), the corporation must disclose any foreign taxes paid or accrued on interest income.
Column 2(e) Rents, Royalties, and License Fees
For column 2(e), the corporation must disclose any foreign taxes paid or accrued on rents, royalties, and license fees.
Column 2(f) Other
For column 2(f), the corporation must disclose any foreign taxes paid or accrued on income not specifically reportable in columns 2(a) through 2(f).
Column 2(g) Sales
For column 2(g), the corporation must disclose any foreign taxes paid or accrued on the portion of sales income sourced to a foreign country. This does not include taxes withheld at source reported in column (f).
Column 2(h) Services Income
For column 2(h), the corporation must disclose any foreign taxes paid or accrued on the portion of sales income sourced to a foreign country.
Column 2(i) Other
For column 2(i), the corporation must disclose any foreign taxes paid or accrued on income not specifically reportable on columns 2(g) and 2(h).
Column 2(j) Total Foreign Taxes Paid or Accrued
For column 2(j), the preparer must add columns 2(a) through 2(j).
Column 3 Tax Deemed Paid
According to the instructions promulgated by the IRS, for column 3, the preparer must enter the total of the taxes deemed paid that corresponds with the identifying number specified on the corresponding line of Schedule A, column 1, with respect to the following amounts:
1. The taxes deemed paid under Section 960(a) in Schedule C, column 7.
2. The taxes deemed paid under Section 960(b) as reported in Schedule E, Part 1, column 5.
3. The taxes deemed paid under Section 902 and Section 960 as reported in Schedule F-1, Part 1, column 12; Part 11, column 8(b); and Part III, column 8.
The preparer should enter on the Schedule B, Part 1 line that corresponds with Schedule A line with “951A” in column 2 the tax deemed paid under Section 960(d) to the total amount reported in Schedule D, Part II, column 4. The preparer should enter on the Schedule B, Part I line that corresponds with Schedule A line “965” in column 2 the tax deemed paid with respect to inclusions under Section 965 equal to the amount reported on line 9 of Schedule H (Form 965), Section 1.
Part II- Separate Foreign Tax Credit
Line 1a. Total Foreign Taxes Paid or Accrued
The corporation should enter the sum of column 2(j) on line 1a of Part II.
Line 1b. Foreign Taxes Paid or Accrued by the Corporation During the Taxable Year that were Suspended Due to the Rules of Section 909 and for Which the Related Income is Taken into Account by the Corporation
For line 1b, if the corporation had a foreign tax credit splitting event in a prior year that resulted in a suspension of foreign taxes under Section 909, enter the amount of those taxes attributed to related income taken into account in the current tax year. The amount of taxes suspended in a prior year should have appeared on Schedule G, line E, on Form 1118 for the prior tax year.
By the way of background, foreign taxes are generally treated as paid by the person or entity on whom foreign law imposes legal liability. Under this rule, the person or entity who has legal liability for a foreign tax can be different than the person or entity who realizes the underlying income under U.S. tax principles, resulting in a separation or “splitting” of the foreign income to which the taxes relate. In some cases, this “splitting” can result in foreign taxes being transferred to the U.S. without the associated income being subject to tax in the U.S.. Congress enacted Internal Revenue Code Section 909 to address this issue. Under Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income paid or accrued by the taxpayer, the foreign income tax is not taken into account for U.S. tax purposes before the year in which the related income is taken into account by the taxpayer.
Thus, any suspended taxes as the result of Section 909 should be stated on line 1b.
Line 2. Total Taxes Deemed Paid
For line 2, the corporation should enter the total taxes deemed paid from Part 1, column 3.
Line 3. Reduction of Taxes Paid, Accrued, or Deemed Paid
For line 3, the corporation should enter the reduction of taxes paid, accrued, or deemed paid from Schedule G.
Line 4. Taxes Reclassified Under High-Tax Kickout
For line 4, the corporation should enter the taxes reclassified under the high-tax kickout rules. To limit the use of excess foreign tax credits established by high-taxed foreign passive income, the Internal Revenue Code created an exception known as the high-tax kick out rules. According to these rules, if foreign passive income is taxed at a higher rate by the foreign country than the maximum U.S. federal corporate rate, there is a requirement to “kick-out” the income from the passive foreign tax credit basket. The high-taxed passive income is reclassified into a general income basket. This recharacterization results in a reduction of available foreign tax credits and may prevent a corporation from being able to carryback the excess passive foreign tax from the current year to offset a prior-year foreign passive income.
If the corporation is reclassifying high-taxed income from passive category income, the preparer must enter the related tax adjustment on line 4. The preparer must also indicate whether the adjustment is positive or (negative).
Line 5. Sum of Carryover of Foreign Taxes
For line 5, the preparer must enter the total amount of foreign taxes carried forward or back to the current year. The amount of foreign taxes carried forward to the current year is the amount from Schedule K (Form 1118), line 3, column (xiv), plus the amount from Schedule I (Form 1118), Part III, line 3. Attach Schedule I (Form 1118) and Schedule K (Form 1118) to Form 1118.
Line 6. Total Foreign Taxes
For line 6, the preparer must enter the total foreign taxes. This is the sum of lines 1a through 5a.
Line 7. Enter the Amount From Schedule J
For line 7, according to the IRS instructions, if the corporation has a current overall domestic loss or recapture of an overall domestic loss account, or, in any of its separate categories, a current year separate limitation loss, an overall foreign loss, recapture of an overall foreign loss, or current year separate year limitation income in a category in which it has a beginning balance of income that must be recharacterized, adjustments must be made.
Line 8a. Total Income
For line 8a, the preparer must enter the total taxable income of the corporation from all sources.
Line 8b. Adjustments
For line 8b, according to the instructions, the corporation must enter as a positive amount taxable income that should not be taken into account in computing the foreign tax credit limitation. These adjustments will decrease the net worldwide taxable income reported on line 8c. The preparer must also enter as a negative amount adjustments that increase the net worldwide taxable income reported on line 8c. For example, the net worldwide taxable income you report on line 8c should not include expenses allocated and apportioned to dividends for which a dividends received deduction is allowed under Section 245A. Because the line 8a amount (taxable income from your tax return) includes these expenses, a positive adjustment is needed to back out these expenses (thus increasing the net worldwide taxable income reported on line 8c). As such, the preparer should include as a negative adjustment on line 8b expense amounts from Schedule H, lines 5 and 6.
Line 8c.
For line 8c, according to the instructions, if the negative adjustments included on line 8b (such as those amounts coming in from Schedule H, lines 5 and 6) exceeds any positive adjustments that are also included on line 8b, the net line 8b adjustment will be negative. When this negative amount on line 8b is subtracted from a positive taxable income amount on line 8a, the result will be a positive line 8c amount that is larger than the positive amount on line 8a.
Line 9.
For line 9, according to the instructions, the preparer should divide line 7 by line 8c to determine the limitation fraction. Enter the fraction on line 9 as a decimal with the same number of places as the number of digits to the left of the decimal in adjusted taxable income on line 8c. For example, if adjusted taxable income on line 8c id $100,000, compute the limitation fraction to 6 decimal places.
Line 10.
For line 10, the preparer should enter the total U.S. income tax paid against the credit allowed (minus any American Samoa economic development credit).
Line 11.
For line 11, entitled “credit limitation,” according to the instructions, the limitation may be increased under Section 906(c) (Section 960(b) for pre-2018 foreign corporate tax years) for any year that the domestic corporation receives a PTEP distribution. If an increase in the limit exceeds the domestic corporation’s U.S. income tax liability, the excess is deemed an overpayment and can be claimed on the domestic corporation’s income tax return as a refundable credit.
Line 12.
For line 12, the preparer should enter the smaller of line 6 or line 11.
Part III- Summary of Separate Credits
Line 1. and Line 2. Credit for Taxes on Section 951A Category Income and Foreign Branch Category Income
For taxable years that begin after December 31, 2017, in addition to general and passive category income, the 2017 Tax Cuts and Jobs Act added two new categories of income to which the Section 904 foreign income tax limitation applies- non-passive GILTI Income and foreign branch income. For line 1 and line 2, the corporation must allocate the corporation’s GILTI and foreign branch income respectively.
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. “Inclusion percentage” means, with respect to a domestic corporation, the ratio of such domestic corporation income inclusion for the taxable year to the aggregate of such corporation’s pro rata share of the position of each CFC as to which it is a U.S. shareholder for the taxable year. Tested foreign income means, with respect to any domestic corporation that is a U.S. shareholder’s foreign income taxes paid or accrued by the corporation which are properly attributable to the tested income of the corporation taking into account under Section 951A. Taxes of a foreign corporation with tested losses are not taken into account.
Foreign branch income is defined as business profits (other than passive category income) attributable to one or more QBU as any separate and clearly identified unit of a trade or business that maintains separate books and records. A foreign branch operation of a U.S. corporation would in most instances be a QBU. the branch must, however, be conducting activities that constitute a trade or business. Determining whether activities are a trade or business for this purpose depends upon an analysis of all the surrounding facts and circumstances. The foreign branch basket is based on the income of the corporation’s QBU.
Line 3. and Line 4. Credit for Taxes for Passive and General Income
For lines 3 and 4, the corporation must allocate foreign taxes to passive and general 904 baskets.
Line 5. Credit for Taxes on Section 901(j) Category Income
For line 5, the preparer must make an allocation for taxes for Section 901(j) income.
Line 6. Credit for Taxes on Income Re-Sourced by Treaty
For line 6, the preparer must make an allocation for taxes for income resourced by a treaty.
Line 7. Total
For line 7, the preparer must enter the sum of lines 1 through 6.
Line 8. Reduction in Credit for International Boycott Operations
For line 8, if the corporation participates in or cooperates with an international boycott, the foreign tax credit may be reduced. In this case, the preparer needs to complete Form 5713, International Boycott Report. If the corporation chooses to apply the international boycott factor to calculate the reduction in the credit, enter the amount from line 2a(3) of Schedule C (Form 5713) on line 8.
Line 9. Total Foreign Tax Credit
For line 9, the preparer should subtract line 8 from line 7 for the total foreign tax credit.
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.