By Anthony Diosdi
If you are involved in the preparation of international information returns, you may have noticed on Forms 1116 and 1118 line items for “high-tax kickout.” The instructions promulgated by the Internal Revenue Service (“IRS”) for Forms 1116 and 1118 do a poor job defining the term “high-tax kickout.” This article attempts to clarify the meaning of “high-tax kickout” and its impact on claiming foreign tax credits. By way of background, Internal Revenue Code Section 904 requires that foreign tax credits be calculated separately for each type of foreign-source income included in a particular category or basket. There are currently five baskets for calculating foreign tax credits. They are: 1) passive income; 2) general income; 3) foreign branch income; and 4) GILTI income.
The high-tax kickout rule applies when the effective tax rate for foreign source income allocated to the passive basket exceeds the greatest U.S. tax rate. Under the high-tax kickout rule, the high-taxed income is removed from the passive basket and reallocated to the general income category. The first and most significant impact of the high-tax kickout rule is to prevent cross-crediting within the passive income basket. Second, the high-tax kickout prevents the manipulation of expenses allocation rules of shifting taxes from limitation categories with excess credits to categories with excess limitations.
For example, assume a CFC with excess credits in the general limitation category can engage in simultaneous loans, one as borrower and the other as lender, to create equal amounts of interest income and expenses; the interest income may be entirely passive limitation income, but the corresponding interest expense is apportioned to reduce taxable income in all limitation categories (as well as U.S. source income). The tax effect of this transaction (which is a “wash,” from an economic perspective) is that high foreign taxes actually paid on general limitation income are attributed to income in the passive limitation category and thus may offset residual U.S. tax on other low-taxed passive income. The high-tax kickout, together with the “netting” rule of Treasury Regulation Section 1.904-5(c)(2) (which allocates related person interest expenses of a CFC directly against passive income of the CFc), inhibits this manipulation of the expense allocation rules.
Treatment of Foreign Losses Associated With The High-Tax Kickout
Under Internal Revenue Code Section 904(f)(5), a separate limitation loss (i.e., an excess of deductions allocated to foreign source income in a separate limitation category over the income in that category) is reallocated to other separate limitation categories in proportion to the income in those categories. When income is generated in the loss category in a subsequent year, that income is reallocated to the categories previously reduced by the loss in order to recapture the loss.
Similarly, an overall foreign loss reduces taxable U.S. source income in the year generated and thus the U.S. tax on U.S. source income earned in that year. Section 904(f) recaptures the loss, however, by re-sourcing foreign source income earned in a later year as domestic source. Re-sourcing applies to an amount of foreign source income equal to the amount of the overall foreign loss, but the amount re-sourced in any single year is limited to 50 percent of the entities’ or individual’s foreign source income in that year.
The effect of the re-sourcing is to reduce the foreign tax credit limitation in the subsequent year(s); the amount of U.S. tax may be increased by a corresponding amount, in which case the rule effectively recaptures the prior reduction in U.S. tax on U.S. source income that resulted from the foreign source loss. This rule is intended to prevent U.S. entities and individuals from deriving a “double benefit,” i.e., a deduction to reduce U.S. tax on U.S. source income and the ability to claim a foreign tax credit in a later income year.
These reallocation and recapture rules introduce considerable complexity to the foreign tax credit determination.
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: 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.