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 ninth 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 G
Schedule G of Form 1118 is designed to report any reductions of the deductibility of foreign credits claimed by a domestic corporation.
Part 1- Reduction Amounts
Line A. Reduction of Taxes Under Section 901(e)
Line A asks the preparer to reduce taxes under Section 901(e). Internal Revenue Code Section 901(e) reduces the amount of creditable foreign taxes on foreign mineral income if a corporation claims percentage depletion under Internal Revenue Code Section 613. If the corporation claims a deduction for percentage depletion under Section 613 with respect to any part of its foreign mineral income for the tax year, any foreign taxes on that income must be reduced by the smaller of: 1) the foreign taxes minus the tax on that income, or 2) the tax on that income determined without regard to the deduction for percentage depletion minus the tax on income.
The preparer must report any Section 901(e) reduction on a country-by-country basis. The preparer must attach a separate schedule to the Form 1118 showing the reduction allocated to each applicable country.
Line B. Reduction of Foreign Oil and Gas Taxes
The preparer should enter any reduction of foreign oil and gas taxes from Schedule I, Part II, line 4 on this Line B.
Line C. Reduction of Taxes Due to International Boycott
The preparer should enter the reduction of taxes due to “International Boycott Provisions” on this line. If the domestic corporation chooses to calculate the reduction in the foreign tax by identifying taxes specifically attributable to participation in or cooperation with an international boycott, enter the amount from Schedule C, line 2b.
Line D. Reduction of Taxes for Section 6038(c) Penalty
The preparer should enter the reduction of taxes for the penalty found in Internal Revenue Code Section 6038(c). If the domestic corporation controls a foreign corporation and fails to timely file a Form 5471, Form 1118, or any information in any return required under Section 6038(a) by the due date, the Internal Revenue Code reduces the foreign taxes available for credit under Sections 901, 902 (for pre-2018 foreign corporate tax years), and 960 by 10 percent. If the failure continues for 90 days or more after the date of written notice by the IRS, reduce the tax by an additional 5 percent for each 3-month period or fraction thereof during which the failure continues after the 90-day period has expired. See IRC Section 6038(c) for limitation and special rules. The purpose of line D for Schedule G is to report any reductions to foreign tax credits as a result of a late filing of an informational return.
Line E. Taxes Suspended under Section 909
For line E, the preparer must enter the foreign taxes paid or accrued during the current year that have been suspended due to the rules of Section 909. In order to answer line E for Schedule G, the preparer must understand the so-called “technical taxpayer rule.” Foreign taxes are generally treated as paid by the person or entity on whom foreign law imposes legal liability. Under this “technical taxpayer” 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 flowing up to the United States without the associated income being subject to tax in the United States. Congress enacted Internal Revenue Code Section 909 to address this issue.
Under Internal Revenue Code Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by the domestic corporation, the foreign income tax is not taken into account for U.S. tax purposes before the tax year in which the related income is taken into account by the domestic corporation. In the case of indirect foreign credits, foreign income tax paid by the domestic corporation as part of a splitting event is taken into account in the tax year in which the related foreign income is taken into account by the domestic corporation for U.S. income tax purposes.
Line F. Other Reductions of Taxes
For line F, the preparer should enter the applicable two-letter codes from the list at IRS.gov/CountryCodes for the reduction for taxes associated with any applicable foreign country. If there is a reduction in foreign tax credits from more than one foreign jurisdiction, the preparer should attach a schedule to the Schedule.
Part II- Other Information
The preparer must check the box stated on line G if the domestic corporation paid or accrued any foreign tax that was disqualified for a credit under Internal Revenue Code Section 901(m). By way of background, in 2010, The Education Jobs and Medicaid Funding Act added Section 901(m) to the Internal Revenue Code. Section 901(m) partially denies a foreign tax credit in situations when Section 338, Section 754 or a check-the-box election results in the creation of additional asset basis eligibility for recovery for U.S. tax purposes where the corresponding increase in the basis of the asset for foreign tax purposes. A foreign tax credit is denied to the extent of the aggregate basis difference allocable to a particular tax year with respect to all relevant foreign assets divided by the income on which the foreign income is determined. To the extent that a foreign tax credit is disallowed, the disqualified portion may be allowed a deduction.
If any portion of a foreign tax credit was disqualified as a result of Section 901(m), the preparer should check the box provided for on line G.
The preparer must check the box stated on line H if the domestic corporation paid or accrued any foreign tax that was disqualified for a foreign tax credit under Sections 901(j), (k), or (l) of the Internal Revenue Code.
By way of background, Internal Revenue Code Section 901(j) denies foreign tax credits for taxes paid to any country 1) the government of which the United States does not recognize, unless such government is otherwise eligible to purpose defense articles or services under the Arms Export Control Act; 2) with respect to which the United States has severed diplomatic relations; 3) with respect to which the has not severed diplomatic relations but does not conduct such relations, or 4) which the Secretary of State has, pursuant to Section 6(j) of the Export Administration Act of 1979, as amended, designated as a foreign country which has repeatedly provides support for acts of international terrorism.
Under Section 901(j)(5), the denial of the foreign tax credit with respect to a foreign country will not apply if two conditions are met. First, the President determines that a waiver of the denial of the foreign tax credit is in the national interest of the United States and will expand the trade and investment for U.S. companies in the foreign country. Second, not less than 30 days before the granting of the waiver of the foreign tax credit, the President must report to Congress the intention to grant the waiver and the reason for granting the waiver.
Section 901(k) generally denies a shareholder any direct or indirect foreign tax credits with respect to a dividend on stock in a corporation if a shareholder has not held the stock for a minimum period during which the shareholder is not protected from risk of loss. For dividends on common stock, the minimum holding period is 16 days within the 31-day period starting 15 days before the ex-dividend date. In the case of preferred stock, the stock must be held for 46 days within the 91-day period starting 45 days before the ex-dividend date. Furthermore, the provision generally denies a shareholder any foreign tax credits, regardless of the shareholder’s holding period for the stock, to the extent that the shareholder has an obligation to make payments (whether through a short sale or otherwise) related to the dividend with respect to substantially similar or related property. There are several exceptions to this foreign tax credit disallowance rule, including one for foreign tax credits with respect to dividends received by securities dealers engaged in the active conduct of a foreign securities business. Congress explained the [policy underlying Section 901(k), as follows:
Although present law imposes a holding period requirement for the dividends-received deduction for a corporate shareholder (Sec. 246), there are no similar holding period requirements for foreign tax credits with respect to dividends. As a result, some U.S. persons have engaged in tax-motivated transactions designed to transfer foreign tax credits from persons that are unavailable to benefit from such credits (such as a tax-exempt entity or a taxpayer whose use of foreign tax credits is prevented by the limitation) to persons that can use such credits. These transactions sometimes involve a short-term transfer of ownership of dividend-paying shares. Other transactions involve the use of derivatives to allow a person that cannot benefit from the foreign tax credits with respect to a dividend to retain the economic benefit of the dividend while another person receives the foreign tax credit benefits. See H.R. Rep. No. 148, 105th Cong., 1st Sess. 545 (1997).
The 2004 JOBS Act added Section 901(l) to the Internal Revenue Code. Section 901(l) provides a minimum holding period rule for income other than dividends. Under this rule, no foreign tax credit will be allowed for any withholding tax on any item of income or gain with respect to any property 1) if the property is held by the recipient of the income item for 15 days or less during the 31-day period starting on the date that is 15 days before the date on which the right to receive payment of the income item arises or 2) to the extent that the recipient of the income item is under an obligation (whether under a short sale or otherwise) to make related payments with respect to positions in substantially similar related property. This minimum holding period requirement does not apply to “any qualified tax with respect to any property in the active conduct in a foreign country of a business as a dealer in such property.”
If any Sections 901(j), (k), or (i) apply to the domestic corporation, the box on line H must be checked.
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: 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.