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. Recently, the Global Intangible Low-Taxed Income (“GILTI”) made some made changes to the way foreign tax credits are computed. This article discusses the changes in the way foreign tax credits are computed under the GILTI regime.
Because the United States taxes U.S. persons on their worldwide income, a system of foreign tax credits was enacted in 1918. Foreign tax credits were enacted to prevent U.S. taxpayers from being taxed on their foreign-source income by both the foreign country where the foreign source income was earned and by the United States. Foreign tax credits allow U.S. taxpayers to reduce U.S. income tax on its foreign source income. In order for a foreign tax to be eligible for a foreign tax credit, the foreign tax must be an “income, war profits (or) excess profits tax paid or accrued …to any foreign country or to any possession of the United States.” See IRC Section 901(b). A foreign tax credit is also allowed under the Internal Revenue Code for a “tax paid in lieu of a tax on income…otherwise generally imposed by any foreign country or by any possession of the United States.” See IRC Section 901(b). Internal Revenue Code 901(a) provides a “direct” credit or deduction against U.S. tax on foreign-source income for foreign taxes directly paid or accrued by a U.S. person.
Internal Revenue Code Section 960 adopted a new “properly attributable to” standard to determine the amount of foreign taxes deemed paid by U.S. shareholders of Controlled Foreign Corporation (“CFC”). Section 960 applies to certain income inclusions from CFCs, including amounts included in the U.S. Shareholder’s gross income. Internal Revenue Code Section 960(a) now provides that U.S. corporate shareholders must include “any item of income under Internal Revenue Code Section 951(a)(1) with respect to any CFC shall be deemed to have paid “so much of such foreign corporation’s foreign income taxes as are properly attributable to such item of income.” (In effect, Internal Revenue Code Section 951(a) treats U.S. shareholders of CFCs as having received a current distribution out of subpart F income).
Thus, as a threshold matter, Section 960(a) provides a basis for deemed-paid credits with respect to inclusions under Internal Revenue Code Section 951(a)(1)(A). (Subpart F inclusions). Internal Revenue Code Section 960 also provides a basis for deemed-paid credits with respect to inclusion for Section 951A (GILTI), and Section 956 (Foreign Base Company Income) inclusions. (Internal Revenue Code 956 is an anomaly and operates differently than the rest of subpart F. Generally, a U.S. shareholder must include in his income pro rata share of the CFC’s increase in its E&P invested in U.S. property for the taxable year. For purposes of Section 956, U.S. property includes most tangible and intangible property owned by a CFC). As part of the price of claiming the Section 960 foreign tax credit, a shareholder must gross up the inclusion by the amount of foreign taxes properly attributable to it pursuant to Internal Revenue Code Section 78.
To prevent the use of foreign tax credits to offset U.S. tax on U.S. source income, Internal Revenue Code Section 904 provides various limitations. The overall limitation under Internal Revenue Code Section 904(a) is expressed by a formula:
U.S. Taxes on Worldwide Taxable X Foreign-Source Taxable Income
Income (before foreign tax credits) Worldwide Taxable Income
Foreign Tax Credit Limitation and Baskets
Prior to the Tax Cuts and Jobs Act, a foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income (computed under U.S. tax accounting principles). The limitations was computed by multiplying the taxpayer’s total U.S. tax liability (prior to the foreign tax credit) in that year by the ratio of the taxpayer’s foreign source taxable income in that year to the taxpayer’s worldwide taxable income in that year. The limitation is applied separately to a “passive category income” basket and “general category income” basket. Passive category income included income that would be foreign personal holding company income under Internal Revenue Code Section 954(c) (e.g. dividends, rents, interest, and royalties).
Under the new GILTI provisions of the Internal Revenue Code, in addition to general category and passive category income, GILTI added two new categories of income to which foreign tax credit limitation applies- non-passive GILTI income and foreign branch income. Thus while general limitations apply to non-passive GILTI inclusions, passive GILTI remains in the passive limitation category. Any excess foreign tax credits in the GILTI limitation category do not carry back or forward to other taxable years.
For foreign tax credits applicable to the GILTI basket, there is an 80 percent limitation. Any amount includible in gross income of a domestic corporation under GILTI, such domestic corporation shall be deemed to have paid foreign income taxes equal to 80 percent of the product of such domestic corporation’s inclusion percentage multiplied by the aggregate tested foreign income taxes paid or accrued by CFCs.
As demonstrated above, computing foreign tax credits in the age of GILTI may can be extremely complex matter. As with any international tax matter, there is no one-size-fits-all solution. Individuals and business organizations investing abroad should consult with a qualified tax professionals for foreign tax credit planning.
The tax attorneys at Diosdi Ching & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.
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 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.