By Anthony Diosdi
U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign income taxes paid or accrued. The main purpose of the foreign tax credit is to mitigate the double taxation of foreign source income that might occur if such income is taxed by both the United States and a foreign country. A U.S. taxpayer may receive a “direct” foreign tax credit for foreign taxes that the taxpayer itself pays.
Internal Revenue Code Section 901 limits the foreign tax credit to foreign taxes imposed on “income, war profits or excess profits.” Internal Revenue Code Section 903 extends the credit to foreign taxes imposed “in-lieu-of” an income tax. In order to be creditable under either Internal Revenue Code Sections 901 or 903, a foreign levy must be a “tax.” A levy is a tax “if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes.” A taxpayer’s payment of tax must be compulsory and not voluntary.
The tax must also be levied by the country pursuant to its taxing authority, not some other authority- as a result, penalties, fines, interest, and customs duties are not considered taxes. In addition, a foreign levy is not a tax to the extent the person subject to the levy receives a “special economic benefit” from the foreign country in exchange for a payment.”
The primary beneficiaries of the direct foreign credits are U.S. citizens, corporations, and resident aliens. The basic operation of the direct credit is simple. It principally applies to four situations:
The Corporation Branch. When a U.S. corporation conducts its business in a foreign country directly (rather than through a foreign corporation), it is said to have a branch. Foreign income taxes incurred by the branch are paid directly by the U.S. corporation and therefore qualify for direct credits. In the case of a U.S. corporation that owns at least 10 percent of the voting stock of a foreign corporation, the taxpayer may be entitled to an “indirect” or “deemed” credit for the foreign taxes paid by that foreign subsidiary when foreign income earned by that subsidiary is distributed to the U.S. corporation as a dividend or included in the U.S. corporation’s income under Subpart F. In general, the foreign taxes deemed paid by the U.S. corporation is calculated by reference to the ratio of earnings distributed (or deemed distributed) to the U.S. corporation over the foreign subsidiary’s total earnings and profits.
Earnings through a Partnership or S Corporation. U.S. citizens, resident aliens, and corporations that earn income abroad through an ownership interest in an entity treated as a partnership for federal income tax purposes including a limited liability company treated as a partnership) may claim a direct credit for their distributive shares of the foreign taxes paid by the entity. Similarly, U.S. citizens and resident aliens who earn income abroad through a stock interest in a Subchapter S corporation may claim a direct credit for their pro rata shares of the foreign income taxes paid by the S corporation. A partnership or s corporation is not a taxpaying entity for federal income tax purposes (with certain exceptions, in the case of an S corporation). Instead, the partnership’s or S corporation’s income, expenses and creditable foreign taxes flow through to the owners of the entity.
Individual Earnings. Individual U.S. citizens or resident aliens who earn income abroad and pay foreign income taxes may credit those taxes against their U.S. income tax. In addition to the direct credit available to the foreign branch operation, Internal Revenue Code Section 902 allows an individual credit to a U.S. corporation owning at least ten percent of the voting stock of a foreign corporation and receiving dividends from the voting corporation.
Earnings through a “Hybrid Entity.” A hybrid entity is an entity that is treated as a corporation for U.S. tax purposes and as a fiscally transparent entity or a non-entity (often referred to as a “disregarded entity”) for foreign tax purposes, or vice versa. Although hybrid entities have been part of international transactions for many years, the check-the-box entity classification regulations have made the creation of such entities much easier. Under the current entity classification rules of U.S. federal tax law, a taxpayer generally can elect whether to treat an entity as a corporation or a fiscally transparent entity, unless the entity is a ‘per se” corporation under the regulations that is required to be treated as a corporation for U.S. tax purposes.
Under the “technical taxpayer rule” in Treasury Regulation 1.901-2(f)(1), the taxpayer “on whom foreign tax is treated as paying the foreign tax for foreign tax credit purposes, even if another party remits such tax to the foreign country.” This has led to some interesting tax planning opportunities in which a U.S. taxpayer conducts business abroad through a reverse hybrid foreign entity- a foreign entity that the taxpayer elects to treat as a corporation for U.S. tax purposes but that is treated as a fiscally transparent entity for foreign tax law purposes. Under the foreign tax law, therefore, the income of the entity is treated as the income of the U.S. taxpayer and the U.S. taxpayer has the legal liability for the foreign taxes on such income.
For U.S. federal tax purposes, however, the foreign corporation is treated as a separate entity earning the income. Yet, the U.S. taxpayer will receive a direct foreign tax credit under Section 901 of the Internal Revenue Code for the foreign taxes on such income because the U.S. taxpayer has legal liability for such taxes under the technical taxpayer rule. The income is, thus, separated from the foreign taxes for U.S. tax purposes and the credit for such taxes is accelerated and can be used to offset U.S. residual tax of other low-taxed foreign income of a U.S. taxpayer. For example:
Jim, a U.S. citizen, has $1,000 of foreign-source business income that is subject to no foreign tax in Country A, a tax haven country. Assuming that Jim has paid no foreign taxes on any other income and assuming a 37-percent federal U.S. tax rate on Jim’s income, Jim will own $370 of federal income tax on the $1,000 of foreign-source income. However, suppose that Jim also owns all of the equity interests in a foreign entity that is treated as fiscally transparent for foreign tax purposes (under the laws of Country B, the jurisdiction in which the entity is organized) but that Jim elects to treat as a foreign corporation for U.S. tax purposes- a so-called reverse hybrid entity. The entity earns $1,000 of foreign business income, which is subject to a foreign tax of $370 (i.e., a 37 percent tax). Under the tax law of Country B, Jim is treated as legally liable for the tax on the income of the fiscally transparent entity and, under the technical taxpayer rule in the regulations, Jim is treated as paying $370 of foreign taxes for purposes of Internal
Revenue Code Section 901. However, the entity’s $1,000 of income is the income of the foreign corporation, a separate taxpayer for U.S. tax purposes, not Jim’s income. So Jim may credit $370 of foreign taxes imposed on the entity’s Country B income against the U.S. residual tax of $370 of the $1,000 of foreign business income in Country A, thus eliminating the U.S. tax on such income.
This type of cross-border tax planning was discussed in Guardian Industries Corp. v. United States, 65 Fed. CL. 50 (2005). In Guardian, the Court of Federal Claims held that a U.S. corporation was entitled to a direct credit under Section 901 for Luxembourg taxes paid by one of its “subsidiaries,” a hybrid entity that was treated as a disregarded entity for U.S. tax purposes and as a corporation for Luxembourg tax purposes. The taxes were imposed on the taxable income of the U.S. corporation’s group of Luxembourg tax purposes and the income of such foreign subsidiaries was not subject to current U.S. tax because it constituted foreign-source income of separate foreign taxpayers, the foreign subsidiaries. The court held that the U.S. corporation was entitled to the credit because, under Luxembourg law, the disregarded entity had sole liability for the taxes imposed with respect to the consolidated group’s taxable income and, for U.S. tax purposes, the taxes paid by the disregarded entity were to be treated as paid by the U.S. corporation. Thus, the foreign tax credit was available to the U.S. corporation for foreign taxes on earnings of the foreign operating subsidiaries on which U.S. tax in that case was deferred from U.S. taxation indefinitely. This case, demonstrates the tax planning opportunities that arises from the technical taxpayer rule promulgated under Treasury Regulation Section 1.901-2(f).
Proposed Legal Liability Regulations
In 2006, the Treasury and IRS proposed regulations (the “Proposed Legal Liability Regulations”) amending the technical taxpayer regulations. The Proposed Legal Liability Regulations purport to clarify the application of the legal liability rule under specific factual circumstances. A modified version of these regulations, discussed below, was finalized in February 2012.
With respect to foreign consolidated-type regimes in which foreign tax is imposed on the combined income of two or more persons, including those where the members of the group are not jointly and severally liable for the group’s tax (as was the case in Guardian), the proposed regulations provided that the foreign tax must be apportioned among all the members of the group pro rata based on the relative amounts of net income of each member as computed under foreign law. A foreign tax would not be considered imposed on combined income, however, merely because foreign law 1) permitted one person to surrender a loss to another under a group relief regime; 2) required shareholders to include amounts in income attributable to corporate taxes under an integrated tax system, or 3) required shareholders to include in income amounts under an anti-deferral regime.
The regulations also would have revised the technical taxpayer’s regulations to provide that a reverse hybrid (i.e., an entity that is a corporation for U.S. tax purposes, but a flow-through for foreign tax purposes) is considered to have legal liability under foreign law for foreign taxes imposed on the owners of the reverse hybrid in respect of each owner’s share of the reverse hybrid’s income. The reverse hybrid’s foreign tax liability would be determined based on the proportion of the owner’s taxable income (computed under foreign law) that is attributable to the owner’s share of the reverse hybrid’s income.
Although the proposed regulations addressed the situation in Guardian, they did not address all separation of creditable foreign tax arrangements.
Conclusion
As mentioned above, foreign taxes are generally treated as paid by the person on whom foreign law imposes legal liability. Under this “technical taxpayer” rule, the person who has legal liability for a foreign tax can be different than the person who realizes the underlying income under U.S. tax principles, resulting in a separation or “splitting” of the foreign income to which the tax relate. In some cases, this “splitting” can result in foreign taxes flowing up to the United States without associated income being subject to tax in the United States. In certain cases, with proper planning, these situations can result in substantial tax savings.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP. He represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. 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.