By Anthony Diosdi
For those who are or will be involved in international business and investment transactions, it is important to have some basic understanding of the relevant tax laws. These series of articles are intended to warn individual shareholders of controlled foreign corporations (“CFCs”) (whether individual or corporate) of the mistakes that will likely catch the attention of the Internal Revenue Service (“IRS”) and trigger a potentially costly audit. This article will discuss mistakes CFC shareholders make when claiming credits for foreign income on their U.S. tax returns and should the IRS audit a credit claimed for foreign taxes, the substation necessary to sustain that credit.
Only CFC Corporate Shareholders and Individual CFC Shareholders that Made a Section 962 Election Can Take Foreign Tax Credits Associated with Subpart F or GILTI Income
Virtually all CFCs annually generate subpart F or, more likely Global Intangible Low-Taxed Income (“GILTI”). U.S. shareholders (or shareholders of S corporations or partners of a partnership) must include any subpart F or GILTI inclusions as ordinary income on their individual tax returns. The current highest federal rate applicable to an individual is 37 percent and the highest federal tax rate applicable to a corporation is 21 percent. (Section 250 allows corporations to deduct 50 percent of any GILTI inclusions). The Internal Revenue Code grants a corporate U.S. shareholder a credit of foreign income tax on the CFCs subpart F and GILTI income. (This deemed credit is limited to 80 percent of the foreign taxes imposed on the CFC’s GILTI inclusion).
A foreign taxes paid on subpart F and GILTI inclusions, however, is not available to non-corporate U.S. shareholders. A non-corporate U.S. shareholder of a CFC that is subject to tax on subpart F income or GILTI therefore is effectively subject to two levels of tax on that income: the foreign tax imposed on the CFC and the U.S. tax imposed on the subpart F income or GILTI inclusion. A non-corporate corporate shareholder is permitted to contribute the stock of the CFC to a domestic holding corporation or make a Section 962 election in order to claim foreign tax credits. However, without such planning, a non-corporate U.S. shareholder of a CFC cannot claim a credit for foreign taxes paid. If a non-corporate U.S. shareholder who did not make a 962 election of a CFC claims foreign tax credit to offset U.S. tax on subpart F or GILTI income, the individual is inviting an IRS audit with likely devastating consequences.
The IRS Filing Requirements Associated With Claiming Foreign Tax Credits
Assuming that the non-corporate U.S. shareholder either drops his CFC shares into a domestic corporation or makes a Section 962 election, this individual must properly report the foreign tax credit. A corporation claiming a foreign tax credit must attach Form 1118, Foreign Tax Credit-Corporations to its tax return, whereas an individual claiming a foreign tax credit must attach Form 1116, Foreign Tax Credit, to his or her tax return. A separate Form 1118 or 1116 must be prepared for each category of foreign income.
A foreign tax is creditable if the tax is a compulsory payment that a country imposes in order to raise funds for public purposes. Penalties, fines, interest, and custom duties do not qualify. Creditable taxes also include any foreign taxes imposed “in lieu of” an income tax. The most common type of in-lieu-of tax is the flat rate withholding tax that countries routinely impose on the gross amount of interest, dividends, rents, and royalties derived by passive offshore investors. Withholding is required because it is the only sure way to collect these taxes. A withholding tax generally does not qualify as an income tax because no deductions are allowed in computing the tax base. A withholding tax is creditable, however, if it is imposed in lieu of the foreign country’s general income tax. See Treas. Reg. Section 1.903-1(b)(3), Example 2.
As with other items on a tax return, a CFC shareholder must maintain appropriate documentation to substantiate the foreign tax claimed on a return. Foreign withholding taxes represent some unique problems. This is because the withholding tax is typically paid directly by the CFC shareholder. In this case, the CFC shareholder can obtain indirect evidence of the withholding tax. This may include evidence that the CFC remitted the foreign withholding taxes to the foreign government. Whenever possible, CFC shareholders should attempt to obtain a government receipt for any foreign withholding taxes.
Be Mindful of Foreign Redeterminations and the Requirement to File Amended Returns
If an adjustment by a foreign tax authority results in an increase in the amount of foreign taxes paid, the U.S. shareholder of the CFC has 10 years from the date the return was originally filed to claim a refund of the U.S. taxes. See IRC Section 6511(d)(3)(A). On the other hand, if the redetermination results in a refund of foreign taxes, the CFC shareholder must file an amended tax return on which the CFC shareholder recomputes the U.S. tax liability for the year in which the foreign tax credit was originally claimed. A failure to file an amended return can result in a penalty of up to 25 percent of the deficiency associated with the redetermination. See IRC Section 6689. Redetermined taxes paid are generally translated into U.S. dollars using the exchange rate applicable on the date the foreign income taxes are paid.
Substantiation Requirements Associated With Claiming Foreign Tax Credits
Anytime a U.S. taxpayer (whether individual or corporate) claims a foreign tax credit, the IRS may ask for proof of foreign income taxes paid. The primary substantiation for foreign income taxes paid by a cash basis taxpayer is a receipt for payment. The primary substantiation for foreign taxes paid by an accrual basis taxpayer is a foreign tax return. See Treas. Reg. Section 1.905-2(a)(2). If such documentation is not available, a taxpayer may furnish secondary substantiation. In lieu of a receipt for payment for foreign income taxes paid, a cash basis taxpayer may be able to provide a photocopy of the check, draft or other medium of payment showing the amount and date, with evidence establishing that the tax was paid for the CFC’s account. In lieu of a foreign return for foreign income taxes paid, an accrual basis taxpayer must be able to provide a certified statement of the accrued amount, with excerpts from its books showing the computation of the accrued amount. See Treas. Reg. Section 1.905-2(b).
If you are concerned about the credibility of foreign taxes that was or was not claimed on your U.S. tax return, you should consult with a qualified international tax professional. 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: email@example.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.