Introduction

The United States government taxes its citizens, residents, and domestic corporations on their worldwide income. However, the United States has in place a foreign tax credit regime that alleviates the double taxation of foreign source income by allowing a credit for foreign taxes paid or accrued on such income.

General Overview

The Internal Revenue Code1 taxes domestic taxpayers on all income, from “whatever source derived.” This includes foreign source income. Oftentimes, the foreign source income taxed in the United States is also taxed in the foreign jurisdiction where it is earned, resulting in a heavy double taxation burden and creating an effective tax rate too high to efficiently do business in the respective countries. To alleviate double taxation, the United States instituted the foreign tax credit (“FTC”) in 1918.

There are two types of FTCs available to U.S. taxpayers credits for directly paid foreign taxes (“direct FTCs”) (Sections 901 and 903) and credits for indirectly paid foreign taxes (“indirect FTCs”). (Sections 902 and 960). Direct FTCs are based on foreign income taxes on the income from foreign branch and disregarded entity operations owned directly by U.S. taxpayers as well as foreign withholding taxes on dividends, interest, or other payments received by U.S. taxpayers from foreign entities or persons. Indirect FTCs are based on foreign income taxes paid by foreign subsidiaries (and are generally available to corporate shareholders2).

Taxpayers have the annual option of deducting foreign income taxes in lieu of taking FTC, but cannot both deduct foreign income taxes and take an FTC.3 It is generally more advantageous for taxpayers to take the FTC, as it reduces the taxpayer’s tax liability dollar for dollar. When a taxpayer claims an FTC on its income tax return (and completes Form 1118), it must also add back the amount of the FTC in its Schedule M adjustments.

The period of limitation for amendments related to foreign taxes (including the election to claim a credit or deduction) is generally extended to ten years (presumably to allow for audit by foreign

governments)(Section 6511)

Who can claim FTCs

Section 901(b) outlines the taxpayers eligible to claim FTCs. These include:

• • Domestic corporations, U.S. citizens, and U.S. residents;

• • Foreign corporations and nonresident aliens conducting a U.S. trade or business, subject to limitations.

To the extent such persons are partners (or S-Corporation shareholders) or trust and estate beneficiaries, the amounts eligible for FTC are the proportionate shares of the taxes of the partnership (or S corporation) or the estate or trust.

Creditable Foreign Taxes

Generally, section 901(b) allows an FTC for “any income, war profits, and excess profits taxes paid or accrued . . . to any foreign country or to any possession of the Unites States.” A foreign levy is an income tax only if it is a tax and if its predominant character is that of an income tax. Determinations regarding whether a tax is an income tax are to be made independently for each separate foreign levy.

Several rules address whether a levy is a tax in the first place; e.g., the payment must be compulsory.4 In addition, penalties, fines, interest, and similar obligations, along with customs duties, are not considered a tax.5

A foreign tax has the predominant character of an income tax if it is likely to reach net gain in the normal circumstances in which it applies, i.e., it must meet certain realization, gross receipts, and net income requirements and must not be a soak-up tax.6 Thus, the tax must be based on what would be an income realization event under the Code (or in certain cases a pre-realization event), it must be imposed on the basis of gross receipts (or gross receipts computed under a method that is not likely to produce an amount greater than the fair market value); and the base on which the tax is imposed is computed by reducing such gross receipts to permit recovery of significant costs and expenses attributable to the gross receipts. The tax also must not be a soak-up tax, that is, it must not be dependent (by its terms or otherwise) on the availability of a credit for the tax against income tax liability to another country.

A tax paid “in lieu of” an income tax would also be considered an income tax.7 A common “in lieu of” tax is a foreign withholding tax.

There are other limitations on creditability of the income taxes, including but not limited to limitations related to subsidies8 and the rules prescribing who is the technical taxpayer in certain situations.9 In addition, there are other restrictions on taking an FTC, such as the recently enacted rules disallowing the splitting of taxes from related income. (Section 903)

Finally, note that the IRS has denied credits for taxes paid to certain countries in an effort to further foreign policy objectives. In addition, taxpayers who participate in or cooperate with certain international boycott must reduce its FTC based on a boycott factor.

Indirect FTC (Deemed Paid FTC)

Indirect FTCs are based on the creditable foreign taxes paid by a foreign subsidiary. Such taxes are generally “deemed” to be paid by the U.S. shareholder when it receives a dividend distribution (or a deemed dividend, e.g., a subpart F inclusion under section 951) from such subsidiary. Note that as the dividend is distributed up the chain of foreign corporations, the taxes move with such dividend from the tax pool of the lower-tier subsidiary to the upper-tier subsidiary.

As stated above, indirect FTCs are generally available to corporate shareholders (though an individual shareholder may elect to use indirect FTCs in certain circumstances). To qualify for the indirect FTC, a domestic corporation generally must own at least 10 percent of the foreign company’s voting stock (and special rules are provided for indirect ownership). The indirect FTC (or the tax deemed paid by the recipient of the dividend) is calculated based on the following formula:

Foreign Income Taxes X {Dividends (or deemed dividends) / Undistributed Earnings}

This formula generally allows for an indirect FTC only for taxes related to the portion of the earnings of the foreign subsidiary actually included in income by the recipient parent. Section 78 requires that any such inclusion be “grossed up” by the amount of the deemed paid FTC, i.e., such indirect FTC is treated as a dividend. The indirect FTCs are subject to other rules and limitations, not discussed here.

Foreign Tax Credit Limitation

The maximum FTC that can be claimed by the U.S. taxpayer is limited to the lesser of foreign income taxes paid (or deemed paid) or the foreign tax credit limitation. Such limitation is in place to prevent taxpayers from claiming more tax credits than the amount of U.S. income tax effectively imposed on foreign source income. The limitation is computed with the following formula:

Foreign Source Taxable Income      X                   US Tax

Worldwide Taxable Income                           Before Credits

Such calculation is applied to separate categories of income (Section 904(d).

Excess FTCs occur when FTCs are greater than the U.S. tax liability on the U.S. taxpayer’s foreign source income. Oftentimes this occurs when the foreign jurisdiction has a higher income tax rate than the U.S. rate. These excess credits can be carried back one year and forward up to 10 years.

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1 Unless otherwise indicated, all references to “section” or “§” are to sections of the Internal Revenue Code of 1986, as amended, (“Code”) or the U.S. Department of Treasury regulations promulgated thereunder (“Regulations” or “Treas. Reg.”).

2 But see I.R.C. § 962 (providing an option for individuals take indirect FTCs in certain circumstances).

3 See I.R.C. §§ 164 (allowing deductions for certain taxes). See also I.R.C. § 904(c) and Treas. Reg. § 1.901-1(c) (addressing the mutually exclusive application of deduction and credit provisions to taxes, including in carryover and carryback scenarios).