By Anthony Diosdi
During this extended tax season we received a significant number of questions regarding computing the proper exchange rate for purposes of claiming foreign tax credits. Many international tax practitioners are perplexed by the rules governing currency conversions and foreign taxes.This article is designed to provide guidance regarding translating foreign taxes into U.S. dollars.
Under Internal Revenue Code Section 986, a taxpayer that uses the accrual method to account for foreign taxes for purposes of the foreign tax credit generally translates foreign income 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 the liability for which is denominated in any inflationary currency. This rule also does not apply to a taxpayer that uses the cash method to account for foreign taxes. All foreign taxes that do not qualify for translation at the average exchange rate for the year must be translated at the exchange rate in effect for the date of payment of the taxes to the foreign country. See IRC Section 986(a)(2)(A).
The 2004 JOBS Act added Section 986(a)(1)(D) to the Internal Revenue Code. Section 986(a)(1)(D) provides an election for a taxpayer that otherwise is required under Internal Revenue Code Section 986(a)(1)(A) to translate foreign taxes into U.S. dollars using the average exchange rate for the tax year. This election applies to “any foreign income taxes the liability for which is denominated in any currency other than in the taxpayer’s functional currency.” Under this provision, such a taxpayer may elect to use the exchange rate at the time that the foreign taxes are paid instead of the average exchange rate for the tax year. Once made, the election applies to the tax year for which it was made and all later tax years unless revoked with the Service’s consent.
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 taxpayer must notify the IRS, which will redetermine the taxpayer’s U.S. tax liability. See IRC Section 905(c)(1)(A). A redetermination will also take place for any portion of accrued foreign taxes that remain unpaid more than two years after the close of the tax year to which the taxes relate. However, if the foreign income tax is paid within the two-year period, no redetermination will be made even though the actual U.S. dollar value of the foreign tax paid may differ from the accrued amount due to foreign currency fluctuations. See IRC Section 986(a)(1).
What Happens if Foreign Taxes are Refunded or Credited by a Foreign Country?
If foreign taxes are refunded or credited to the taxpayer by a foreign country, the redetermined amount of foreign taxes paid must be translated into U.S. dollars using the exchange rate as of the exchange rate as of the date of the original payment of the foreign 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 the payment of the taxes.
For example, suppose that DC, a domestic corporan 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 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 of year 1. If DC pays 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 foreign currency fluctuations. If, however, any portion of the accrued Country Y tax for year 1 remains unpaid as 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. Rep. No. 220, 105th Cong., 1st Sess. 614-15 (1997).
Conclusion
Determining the exchange rate to determine for foreign taxes paid is extraordinarily complex. If your domestic corporation is attempting to claim a foreign tax credit, 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.