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 eighth 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 F-3
Claiming Foreign Tax Credits Through Multiple Tiers
Schedule F-3 is designed to report foreign taxes deemed paid with respect to dividends from certain fourth, fifth, and sixth-tier controlled foreign corporations (“CFC”s”) out of earnings accumulated in tax years beginning after August 5, 1997. An indirect foreign tax credit is available to the U.S. parent on dividends paid up from a foreign sub subsidiary to a subsidiary and then to the parent. See Former IRC Section 902(b)(2). It is also available on dividends paid up through the chain from a foreign subsidiary. OIn each case the recipient of a dividend is deemed to have paid an appropriate amount of the underlying corporate tax of the payor of the dividend. The deemed-paid amount is then counted as part of the taxes paid by the recipient when it, in turn, pays a dividend to the next level. At each level there must be ownership of at least ten percent of the voting stock of the next level subsidiary. Moreover, in a two-tier case the first level ownership percentage multiplied by the second level ownership percentage must equal at least five percent and in a three-tier case the percentage of the first, second, and third levels, all multiplied together, again must equal at least first percent. See IRC Section 902(b)(2)(B). Thus, in a three-tier case, 50 percent ownership at the first level, 20 percent at the second level and 50 percent at the third level would just qualify. 50% x 20% x 50% = 5%.
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, the Section 902 foreign tax credit was also available with respect to foreign subsidiaries below the third tier in a chain of foreign subsidiaries of a U.S. parent corporation but only if the foreign subsidiary was a CFC and the US parent corporation was a United States shareholder (as defined in Section 951(b)) in such a foreign corporation. In such a case, the Section 902 foreign tax credit calculation will take into account taxes paid by a fourth-tier, fifth-tier, or sixth-tier foreign subsidiary only with respect to periods during which the foreign subsidiary was a controlled foreign corporation. See Former IRC Section 902(b)(2). At each level there must be ownership of at least ten percent of the voting stock of the next lower level foreign subsidiary. Moreover, in a multiple-tier case the percentage of all the levels, multiplied together, must equal at least five percent. See Former IRC Section 902(b)(2)(B). No indirect foreign tax credit was ever allowed with respect to dividends and foreign taxes paid by a foreign subsidiary below the sixth tier in a chain of foreign corporations. See Former IRC Section 902(b)(2)(B)(iii).
Calculating the Indirect Foreign Tax Credit Prior to Tax Reform
Prior to Tax Reform, when a U.S. corporation received a dividend from a foreign corporation in which it owned at least ten percent of the voting stock, Section 902(a) provided that an indirect foreign tax credit was calculated by the following formula:
Foreign
Amount of dividend corporation’s
Indirect Credit = (not grossed up under Section 78) x post-1986
Foreign corporation’s post-1986 foreign taxes
Undistributed earnings taxes
The concept of this formula was that each dividend distribution from the foreign corporation to the U.S. corporation from the pool of post-1986 earnings carried with it a proportionate amount of the post-1986 foreign taxes.
The numerator of the Section 902(a) fraction is determined in accordance with the rules of Section 316 for determining when a distribution from a U/S. corporation is treated as a dividend. The earnings and profits of the foreign corporation are divided into 1) current earnings (earnings and profits as of the close of the current tax year unreduced by any distributions made during the year) and 2) accumulated earnings. A distribution is treated as a dividend to the extent that it is paid out of either current earnings or accumulated earnings. Furthermore, a distribution will be treated as a dividend if it is covered by earnings during the year at issue. In determining the denominator of the Section 902 fraction, the earnings and profits (or deficits) of a foreign corporation are to be “determined according to rules substantially similar to those applicable to domestic corporations.”
Part I- Tax-Deemed Paid by Third-Tier Foreign Corporations
Section A- Dividends Paid Out of Post-1986 Undistributed Earnings
Column 1a. Name of Foreign Corporation
For column 1a, the preparer should enter the name of the Fourth-tier foreign corporation and the name of the first-tier foreign corporation to which it paid a dividend out of post-1986 undistributed earnings.
Column 1b. EIN
For column 1b, the preparer must enter the EIN of the foreign corporation for the fourth-tier foreign corporation that paid dividends out of post-1986 undistributed earnings.
Column 1c. Reference ID Number
Enter the reference ID number for the fourth-tier foreign corporation that paid dividends out of post-1986 undistributed earnings.
Column 2. Tax Year End
Enter the year and month in which the fourth-tier foreign corporation’s U.S. tax year ended using format YYYYMM that paid dividends out of post-1986 undistributed earnings.
Column 3. Country of Incorporation
For column 3, the preparer must enter the applicable two-letter codes from the list at IRS.gov/CountryCodes for the fourth-tier foreign corporations that paid dividends out of post-1986 undistributed earnings.
Column 4. Post-1986 Undistributed Earnings (in functional currency)
For column 4, the preparer must enter the fourth-tier corporation’s post 1986 undistributed earnings pool (in functional currency) for the separate category for which this schedule is being completed.
Post-1986 undistributed earnings and profits is computed as of the close of the four-tier foreign corporation’s taxable year in which it distributes the dividends and equals the cumulative amount of the foreign corporation’s undistributed earnings and profits for taxable years beginning after December 31, 1986 to December 31, 2017. Post-1986 undistributed earnings and profits is reduced by actual dividend distributions from prior taxable years, as well as any prior year inclusions of the foreign corporation’s earnings and profits in a shareholder’s income (e.g., income inclusions under subpart F). However, post-1986 undistributed earnings and profits are not reduced by a dividend distribution or any other inclusion in a shareholder’s income for the current taxable year. See Former IRC Section 902(c)(1) and Treas. Reg. Section 1.902-1(a)(9).
For the most part, the four-tier foreign corporation’s earnings and profits equals its taxable income, plus or minus various adjustments (such as taxes). Examples of required adjustments include adding back tax-exempt income, adding back the excess of accelerated depreciation over straight-line depreciation, and subtracting foreign income taxes. See IRC Section 312; Treas. Reg. Section 1.902-1(a)(9)(iii). In all cases, a foreign corporation’s post 1986 earnings and profits are determined according to substantially the same U.S. tax accounting principles that apply to domestic corporations. See Goodyear Tire & Rubber Co., 493 U.S. 132 (1989). As a consequence, financial statements. The same pooling mechanism applies to dividends paid by second-tier foreign corporations if they constitute a controlled foreign corporation (“CFC”) and the U.S. parent corporation is a United States shareholder in the foreign corporation. As a consequence, the fourth-tier corporate financial statements should be adjusted to make them consistent with U.S. accounting principles.
Column 5. Opening Balance Post 1986 Foreign Income Taxes
For column 5, the preparer must enter the opening balance of the second-tier corporation’s post 1986 foreign income taxes pool. This is the fourth-tier foreign corporation’s income taxes paid, accrued, or deemed paid (in U.S. dollars) by the corporation for prior years beginning after 1986 and ending in 2017, reduced by foreign taxes attributable to distributions or deemed inclusions of earnings in prior years.
Column 6a. Foreign Taxes Paid and Deemed Paid for Tax Year Indicated
For column 6a, the preparer must enter the foreign taxes paid or accrued by the fourth-tier corporation, translated into U.S. dollars using the exchange rates specified in Section 986(a). Post-1986 foreign income taxes equal the cumulative amount of a foreign corporation’s foreign income taxes for taxable years beginning after December 31, 1986 (including the foreign income taxes for the year of the dividend), reduced by the amount of foreign income taxes related to prior-year dividend distributions or other inclusions of the foreign corporation’s earnings and profits in a shareholder’s income
(e.g., income inclusions under subpart F), regardless of whether those other shareholders were eligible to claim a deemed paid credit. See Former IRC Section 902(c); Treas. Reg. Section 1.902-1(a)(8).
The term “foreign income taxes” had the same meaning for purposes of the deemed paid credit as it does for purposes of the direct foreign tax credit. First, the levy must be a tax (as opposed to a payment in exchange for a specific economic benefit) that is paid to a foreign country. Second, the predominant character of the tax must be that of an income tax in the U.S. sense.
Foreign corporations usually conduct a significant part of their activities in an economic environment in which a foreign currency is used and usually keep their books and records in a foreign currency. This may create currency translation issues for the domestic corporation completing the Form 1118. This is addressed in Internal Revenue Code Section 986. Under Internal Revenue Code Section 986, a corporation that uses the accrual method to account for foreign taxes for purposes of the foreign tax credit generally translates foreign taxes accrued into U.S. dollars at the average exchange rate for the tax year to which the taxes relate (rather than at the exchange rate for the date of payment). See IRC Section 986(a)(1)(A). This rule does not apply to 1) any foreign income taxes paid more than 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 for the liability which is denominated in any inflationary currency. See IRC Section 986(a)(1)(B), (C). The 2004 JOBS Act added Section 986(a)(1)(D) to the Internal Revenue Code. This election allows corporate taxpayers to utilize the exchange rate at the time foreign taxes are paid instead of the average exchange rate for the tax year. The four-tier foreign corporation must use one of the methods of translation discussed above.
Column 6b. Taxes Deemed Paid
For column 6b, the preparer must state the taxes deemed paid by the fourth-tier corporation for a third tier corporation. When determining deemed paid taxes under Section 960(a) related to a subpart F inclusion from a lower-tier foreign corporation (that is, a corporation, below the first-tier foreign corporation), the amounts of taxes deemed paid must be taken into consideration for each lower-tier foreign corporation.
Foreign income taxes paid by a second-tier foreign corporation pass up to the first-tier foreign corporation if the following requirements are satisfied:
1. The domestic corporation owns 10 percent or more of the voting stock of the first-tier foreign corporation.
2. The first-tier foreign corporation owns 10 percent of the voting stock of the second-tier foreign corporation.
3. The domestic corporation indirectly owns at least 5 percent of the second-tier foreign corporation, determined the percentage ownership at the two levels, and
4. The first-tier foreign corporation receives a dividend from the second-tier foreign corporation. See Former IRC Section 902(b).
Likewise, foreign taxes paid by a third-tier foreign corporation pass up to a second-tier foreign corporation if the following requirements are satisfied:
1. The domestic corporation owns 10 percent of the voting stock of the first-tier corporation.
2. The first-tier foreign corporation owns 10 percent or more of the voting stock of the second-tier foreign corporation.
3. The second-tier corporation owns 10 percent or more of the voting stock of the third-tier foreign corporation.
4. The domestic corporation indirectly owns at least 5 percent of the third-tier foreign corporation, determined by multiplying the percentage ownership at the three levels, and
5. The second-tier foreign corporation receives a dividend from the third-tier foreign corporation. See Former IRC Section 902(b).
Below, please find illustration 1 which provides an example of determining the deemed paid credits of a first and second tier foreign corporation prior to 2017 Tax Reform.
Illustration 1.
USAco, a domestic corporation, owns 100 percent of the shares of FORco1. FORco1 owns 40 percent of the shares of FORco2 and FORco2 owns 10 percent of the shares of FORco3. USAco may take a deemed foreign tax credit for foreign taxes paid by FORco2 because USAco owns more than 10 percent of FORco1 (100%), FORco1 owns 10 percent or more of FORco2 (40%) and USAco indirectly owns at least 5 percent (40%) of FORco3 (100% x 40%). However, even though FORco owns at least 10 percent of FORco3, because the indirect ownership by USAco of FORco3 is less than 5 percent (only 4% – 100% x 10%), USAco may not take a deemed foreign tax credit for foreign income taxes paid by FORco3.
The deemed paid credit also extends to taxes paid or accrued by fourth, fifth, and sixth-tier foreign corporations. To qualify, the corporation in question must be a CFC, the U.S. corporation claiming the credit must be a U.S. shareholder, and the product of the percentage ownership of voting stock at each level from the U.S. corporation down must equal at least five percent. The deemed paid credit is extended to lower tiers only with respect to taxes paid or incurred in years during which the payer is a CFC. a foreign corporation is a CFC if, on any day during the foreign corporation’s tax year, U.S. shareholders own more than 50 percent of the combined voting power of all classes of stock or 50 percent of the total value of the foreign corporation.
These discussed above must be applied to determine the taxes deemed paid by third, fourth, fifth, and sixth tier foreign corporations. For purposes of answering the question stated in column 6, taxes deemed paid will only apply to a fourth and fifth-tier foreign corporations.
Column 7. Post-1986 Foreign Income Taxes
For column 7, the preparer must add columns 5, 6(a), and 6(b).
Column 8. Dividends Paid Out
Column 8a. Dividends of a Fourth-Tier Corporation
For column 8a, the preparer must enter the dividends of a fourth-tier corporation. A dividend from a fourth-tier foreign corporation is counted as part of the taxes paid by the recipient (in this case a third-tier foreign corporation) when it, in turn, pays a dividend to the next level. As with foreign tax credits, at each level of payment of a dividend there must be ownership of at least ten percent of the voting stock of the next level subsidiary. Assuming these rules are satisfied, the dividends of the fourth-tier foreign corporation paid out of its post-1986 undistributed earnings should be entered on column 8a.
Column 8b. Dividends of a Third-Tier Corporation
For column 8b, the preparer must enter the sum of column 8(a) amounts translated into the functional currency of the third-tier foreign corporation at the spot rate of exchange in effect on the date of each distribution. A spot exchange rate is the current price level in the market to directly exchange one currency for another, for delivery on the earliest possible value date.
Column 9.
For column 9, the preparer must divide column 8(a) by column 4.
Column 10.
For column 10, the preparer must multiply column 7 by column 9.
Part II- Tax Deemed Paid by Fourth-Tier Foreign Corporations
Column 1a. Name of Fifth-Tier Foreign Corporation
For column 1a, the preparer must enter the name of the fifth-tier and its related fourth-tier corporation for which taxes were deemed paid.
Column 1b. EIN of Second-Tier Foreign Corporation
For column 1b, the preparer must list the EIN number of the fifth-tier foreign corporation.
Column 1c. Reference ID Number
For column 1c, the preparer must enter the reference ID number for the fifth tier corporation for which deemed taxes were paid.
Column 2. Tax Year End
For column 2, the preparer must enter the year and month of the fifth-tier corporation paying taxes using format YYYYMM.
Column 3. Country of Incorporation
For column 3, the preparer must enter the country of incorporation for the fifth-tier corporation paying taxes from the list at IRS.gov/CountryCodes.
Column 4. Post-1986 Accumulated Profits
For column 4, the preparer must report the fifth-tier foreign corporation’s post-1986 undistributed earnings pool” or earnings and profits.
Post-1986 undistributed earnings and profits of the fifth-tier foreign corporation is computed as of the close of the foreign corporation’s taxable year in which it distributes the dividend and equals the cumulative amount of the foreign corporation’s undistributed earnings and profits for taxable years beginning after December 31, 1986 to December 31, 2017. Post-1986 undistributed earnings and profits is reduced by actual dividend distributions from prior taxable years, as well as any prior year inclusions of the foreign corporation’s earnings and profits in a shareholder’s income (e.g., income inclusions under subpart F). However, post-1986 undistributed earnings and profits are not reduced by the dividend distribution or any other inclusions in a shareholder’s income for the current taxable year. See Former IRC Section 902(c)(1) and Treas. Reg. Section 1.902-1(a)(9).
The fifth-tier foreign corporation’s “post 1986 undistributed earnings” equals its income, plus or minus various adjustments (such as taxes) designed to make earnings and profits a better measure of the corporation’s economic income. Examples of the required adjustments include adding back tax-exempt income, adding back the excess of accelerated depreciation over straight-line depreciation, and subtracting foreign income taxes. See Treas. Reg. Section 1.902-1(a)(9)(iii).
Column 5. Opening Balance in Post-1986 Foreign Income Taxes
For column 5, the preparer must enter the opening balance in post-1986 foreign income taxes of the fifth-tier foreign corporation. The fifth-tier foreign corporation’s post-1986 foreign income taxes equal the cumulative amount of the corporation’s foreign income taxes, reduced by the amount of foreign income taxes related to prior year dividend distributions or other inclusions of the foreign corporation’s earnings and profits in a shareholder’s income (e.g., income inclusions under subpart F).
Column 6. Foreign Taxes Paid and Deemed Paid for the Tax Year Indicated
Column 6a. Taxes Paid
For column 6a, the preparer must enter the foreign taxes paid or accrued by the fourth-tier foreign corporation (in functional currency) to the fifth-tier corporation out of post-1986 accumulated earnings and profits.
Column 6b. Taxes Deemed Paid
For column 6b, the preparer must enter the deemed paid foreign taxes of the fourth-tier foreign corporation.
Column 7.
For column 7, the preparer must add column 5, 6(a), and 6(b).
Column 8. Dividends Paid
8a. Dividends Paid by Fifth-Tier CFC
For column 8a, the dividends paid from a fifth-tier CFC must be disclosed. This must be in the foreign corporation’s function currency of all dividends paid and deemed inclusions out of post-1986 undistributed earnings for the tax year indicated.
8b. Dividends Paid by Fourth-Tier CFC
For column 8b, the dividends paid from a fourth-tier CFC must be disclosed. This must be in the foreign corporation’s functional currency of all dividends paid and deemed inclusions out of post-1986 undistributed earnings for the tax year indicated.
Column 9.
For column 9, the preparer should divide column 8(a) by column 4.
Column 10.
For column 10, the preparer must multiply column 7 by column 9.
Part III- Tax Deemed Paid by Fifth-Tier Foreign Corporation
Column 1a. Name of Sixth-Tier Foreign Corporation and its Related Fifth-Tier Foreign Corporation
For column 1a, the preparer should enter the name of the sixth-tier foreign corporation and the name of the fifth-tier foreign corporation to which it paid a dividend out of post-1986 undistributed earnings.
Column 1b. EIN of the Sixth-Tier Foreign Corporation
For column 2b, the preparer should enter the EIN of the sixth-tier foreign corporation.
Column 1c. Reference ID Number
For column 1c, the preparer should enter the reference ID number of the sixth-tier foreign corporation.
Column 2. Tax Year End
For column 2, the preparer should enter the year and month in which the sixth-tier foreign corporation U.S. tax year ended using format YYYYMM that paid dividends out of post-1986 undistributed earnings.
Column 3. Country of Incorporation
For column 3, the preparer must enter the applicable two-letter codes from the list at IRS.gov/CountryCodes for the sixth-tier and fifth foreign corporations that paid dividends out of post-1986 undistributed earnings.
Column 4. Post-1986 Undistributed Earnings
For column 4, the preparer must enter the sixth-tier corporation’s post 1986 undistributed earnings pool (in functional currency) for the separate category for which this schedule is being completed. The “post-1986 undistributed earnings” of a foreign corporation are the total earnings for years starting in which a dividend is distributed (prior to January 1, 2018), undimished by any dividend distributions made during that year. See Former IRC Section 902(c)(1); Treas. Reg. Section 1.902-1(a)(9)(i).
Column 5. Opening Balance Post 1986 Foreign Income Taxes
For column 5, the preparer must enter the opening balance of the sixth-tier corporation’s post 1986 foreign income taxes pool.
Column 6 Foreign Taxes Deemed Paid for Tax Year Indicated
Column 6a. Foreign Taxes Paid
For column 6a, the preparer must enter the foreign taxes paid or accrued by the sixth-tier corporation, translated into U.S. dollars using the exchange rates in Section 986(a).
Column 6b. Foreign Taxes Deemed Paid
For column 6b, the preparer must enter the amount stated on Schedule F-3, Part 1, column 10.
Column 7. Post 1986 Foreign Income Taxes
For column 7, the preparer must add columns 5 and 6.
Column 8a. Dividends Paid of the Sixth-Tier Corporation
For column 8a, the preparer must enter the dividends of the sixth-tier corporation. A dividend is counted as part of the taxes paid by the recipient when it, in turn, pays a dividend to the next level. As with foreign tax credits, at each level of payment of a dividend there must be ownership of at least 10 percent of the voting stock of the next level subsidiary. Assuming these rules are satisfied, the dividends of the sixth-tier corporation paid out of its post-1986 undistributed earnings should be entered on column 8a.
Column 8b. Dividends Paid of the Fifth-Tier Corporation
For column 8b, the preparer must enter the sum of column 8(a) translated into the functional currency of the fifth-tier foreign corporation at the spot rate in effect on each date of each distribution.
Column 9.
For column 9, the preparer must divide column 8(a) by column 4.
Column 10.
For column 10, the preparer must multiply column 7 by column 9.
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.