U.S. Foreign Tax Credit An Overview 3& KEY ISSUES IN US TAXATION ON UNREPATRIATED EARNINGS • MAJOR FACTORS WHICH EFFECT CALCULATION - Foreign Earnings and Foreign Taxes • Based on US tax concepts e.g. E&P, definition of tax, etc. • May include lower tiers (i.e. not just equity earnings) • Translation rates different for earnings vs taxes - US Parent’s “Attributes” in DISTRIBUTION Year • domestic expenses allocated/apportioned to FSI • Other foreign source income and related taxes • Domestic income/loss position - Year Repatriated vs. Year Earned • Controlled by Company • Decision (at least in part) based on tax cost • Carryback/over Period of 1/10 creates 12 year ‘window’ PricewaterhouseCoopers Page 2 10/21/2004 US Taxation – Assuming No FTC or Deduction for Foreign Taxes US Tax Return US Source Income Foreign Source income Taxable Income US Income Tax US Tax Foreign Tax Worldwide Tax Worldwide ETR PricewaterhouseCoopers Foreign Country Tax Return $1,000 Foreign Source Income 600 $1,600 Taxable Income x .35 $ 560 Foreign Income Tax $560 180 $740 46.25% $600 $600 x .30 $180 [$740/$1,600) Page 3 10/21/2004 US Taxation – With FTC US Tax Return US Source Income Foreign Source income Taxable Income US Income Tax (before FTC) Less FTC US Income Tax (after FTC) US Tax Foreign Tax Worldwide Tax Worldwide ETR PricewaterhouseCoopers Foreign Country Tax Return $1,000 Foreign Source Income 600 $1,600 Taxable Income x .35 $ 560 Foreign Income Tax -180 $380 $380 180 $560 35% $600 $600 x .30 $180 [$560/$1,600) Page 4 10/21/2004 Foreign Tax Credit Overview • Purpose: • Types of • FTC: Minimize double taxation Direct (Secs. 901 & 903) and Indirect (Sec. 902 & 960) • Annual Election: FTC vs. deduction of foreign taxes PricewaterhouseCoopers Page 5 10/21/2004 Why FTC Does Not Eliminate Double Taxation? • • • • • Some foreign tax payments are not creditable Not all U.S. taxes can be reduced by the credit FTC limitation restricts creditability Differences in source of income rules Differences in allocation/apportionment rules PricewaterhouseCoopers Page 6 10/21/2004 FTC Limit Formula • Foreign Foreign Source Tax = Taxable Income x Credit World Wide Limit Taxable Income US Tax Before FTC • Allowed FTC is the lesser of: - Creditable Foreign Income Taxes, or - FTC Limit • [See Form 1118] PricewaterhouseCoopers Page 7 10/21/2004 Foreign Tax Credit Limitation Foreign Tax Credit Limitation is based on taxable income - §904(a): • First, must identify gross foreign-source income in accordance with sourcing rules • Then, must allocate and apportion deductions in accordance with principles of §861(b). This is key, and very difficult, area (covered later in course). PricewaterhouseCoopers Page 8 10/21/2004 Determination of Net Foreign Source Income Taxable Income Foreign Source Gross Income... = • Less: Directly Allocable Expenses and Indirectly Apportioned Expenses • Equals: Net Foreign Source Taxable Income PricewaterhouseCoopers Page 9 10/21/2004 Allocation & Apportionment of Expenses: Basic Concepts •Terminology - Income class - Statutory grouping (e.g., Foreign Source) - Residual grouping (e.g., US Source) •Allocation of deduction to income classes is required •Apportionment of deduction between statutory and residual groupings is required PricewaterhouseCoopers Page 10 10/21/2004 Allocate versus Apportion Example (Apportion) foreign source vs US source PricewaterhouseCoopers (Allocate) classes of gross income Mfg Income Dividends Interest Royalties Rents US Source Foreign Source Page 11 10/21/2004 Allocation & Apportionment: General Methods Allowed (Reg. §1.861-8) •Units Sold •Gross Receipts •Gross Income •Cost of Goods Sold •Profit Contribution •Expenses Incurred PricewaterhouseCoopers •Compensation •Space Utilized •Time •Assets •Any other reasonable method Page 12 10/21/2004 Allocation and Apportionment: Specific Deductions • Special Rules for the allocation and apportionment of the following types of expenses: - Interest - R&D - State Taxes - Charitable Contributions - Legal and Accounting Fees - Stewardship Costs - Supportive Functions (e.g., overhead, G&A, supervisory expenses, etc.) • Deductions in year of repatriation, not year of earnings PricewaterhouseCoopers Page 13 10/21/2004 Allocation and Apportionment: Interest Expense • What is interest expense? - Generally = GROSS interest expense under Sec. 163 (including original issue discount) and modified by capitalization provisions such as Sec. 263A - Also includes interest equivalents (e.g., loan amortization fees) • General Concept - Money is fungible - Interest expense is attributable to all activities and property and must be apportioned based upon assets (foreign and US) • Exceptions: Specific Allocation of Interest Expense - Qualified Non-Recourse Debt - Integrated Financial Transactions - CFC Netting Rule PricewaterhouseCoopers Page 14 10/21/2004 Allocation & Apportionment: Interest Expense (continued) • • • • • Apportioned on affiliated group basis based on assets Use average tax book value or elect to use the fair market value (FMV) Categorize assets based on income that is generated Foreign ratio = Assets of affiliated group generating FSI Total assets of affiliated group • Tax Bill introduces worldwide fungibility approach effective after 2008 PricewaterhouseCoopers Page 15 10/21/2004 Types of Foreign Tax Credits • Direct credit, §901 • In lieu of credit, §903 • Deemed paid credit, §902 and §960 PricewaterhouseCoopers Page 16 10/21/2004 What Foreign Taxes Are Creditable? • Foreign income tax, excess profits, and war profits taxes imposed by a foreign country (Sec. 901(b)) • Foreign income taxes imposed by political subdivisions • Foreign taxes imposed “in lieu of” an income tax (Sec. 903(a)) • Taxes creditable under a tax treaty PricewaterhouseCoopers Page 17 10/21/2004 Foreign Tax Credit Carrybacks/Carryovers • Excess foreign tax credits can be carried back 1(2) years and forward 10(5) years. • If not used by end of 10 (5) years, carryover is lost. • Separate carrybacks and carryovers are used for each basket. • Current year FTCs are used before any carrybacks and carryovers. PricewaterhouseCoopers Page 18 10/21/2004 Deemed Paid FTC: Example • If a US corporation earns foreign income through a branch, the US corp pays the foreign tax directly and receives a credit under Sec. 901 (i.e., a direct credit) US Corp Foreign Branch PricewaterhouseCoopers Foreign Income $1,000 Foreign Tax 250 • US corporation will include $1,000 in gross income and claim a foreign tax credit of $250 Page 19 10/21/2004 Deemed Paid FTC: Example (con’t) US Corp $750 Dividend Foreign Sub PricewaterhouseCoopers Foreign Income $1,000 Foreign Tax 250 Foreign E&P 750 • If a US corporation earns foreign income through a sub and repatriates all the after-tax profits, the US corp has not directly paid any foreign taxes and thus can’t receive a Sec. 901 FTC. • However, under Sec. 902, the US corp will treat the $250 of taxes paid by the foreign sub as a FTC in the U.S. • US corp will include the $1,000 in gross income ($750 dividend plus $250 Sec. 78 gross-up) and claim a foreign tax credit of $250 Page 20 10/21/2004 Deemed Paid FTCs • Sec. 902 and 960 deemed paid taxes - Meets Sec. 902 ownership requirements: • 10% or more of the voting stock of 1st tier foreign corporation • More than 10% direct and 5% indirect voting stock of 2nd – 6th tier foreign corporations (4th-6th tiers must be CFCs) - Must be a corporate shareholder to claim a deemed paid credit - Must include the deemed paid credit as “income” under Sec. 78 (i.e the “Sec. 78 gross up” • Example: If a US shareholder receives a $1,000 dividend from its foreign sub, and the associated deemed paid credit is $300, the gross income to the US Shareholder is $1,300 and the shareholder may claim a $300 FTC against its US tax liability PricewaterhouseCoopers Page 21 10/21/2004 Distributions from Post-’86 E&P • Pooling concept (applied to each separate basket) • Deemed paid credit formula: Dividends E&P Pool X Post-’86 Foreign = Foreign Taxes Credit/ Post-’86 Taxes Pool §78 Gross Up • Therefore, credit effectively based on average effective tax rate during post- ’86 years • Post-86 E&P Pool is kept in local currency until triggering event • Tax pool includes taxes imposed on lower tier subsidiaries that are “deemed paid” by upper tier subsidiaries. Post-86 Foreign Taxes Pool is kept in US$ PricewaterhouseCoopers Page 22 10/21/2004 Calculation of Post-86 E&P • Functional Currency Method Steps Step 1: Obtain entity financial statements in functional currency. Step 2: Adjust financial statements for material US GAAP adjustments in functional currency. Step 3: Adjust entity financial statements to US tax accounting principles in functional currency. Note: E&P related to Pre-1987 tax years may have additional calculation steps. PricewaterhouseCoopers Page 23 10/21/2004 Calculation of Post-86 E&P Obtain Financial Statements (Step 1) • Adjust from Local GAAP to U.S. GAAP (Step 2) - Clear Reflection of Income - Historical Cost - Valuation of Assets and Liabilities Inflation Adjustments - Income Equalization/Group Relief - Foreign Currency • PricewaterhouseCoopers Page 24 10/21/2004 Calculation of Post-86 E&P Adjust from U.S. GAAP to E&P (Step 3) Tax Elections Available Overall Method of Accounting Asset Depreciation (§168(g)) Section 338 Unavailable Accounting Methods LIFO Long Term Contracts (Completed Contracts) Permanent Items Goodwill Amortization (Non §197) Others PricewaterhouseCoopers Sec. 263A Pension Adjustments per Sec. 404A Reserves Currency Gains & Losses Taxes Page 25 10/21/2004 Deemed Paid Credit • Eligible distributions - Actual dividends Consent dividends Subpart F income from CFC Sale of CFC stock (§1248 gain) Other transactions giving rise to dividend treatment from foreign corporation (e.g., certain §367 transactions) PricewaterhouseCoopers Page 26 10/21/2004 FTC - Separate Baskets • Passive Income (i.e. interest, rents, royalties, etc.) • High Withholding Tax Interest (i.e. interest subject to a 5% or more • • • • • • withholding tax) Financial Services Income Shipping Income Foreign Oil Extraction Income Dividends from each Sec. 902 foreign corporation (i.e., 10-50% owner foreign corporations); Post-2002 dividends from 10-50 companies are generally grouped as a single basket of income or placed in baskets based on look through principles (for post 2002 E&P) Certain DISC/FSC dividends and FSC foreign trade income All other income (i.e., the general limitation or the “good” FTC basket) • Tax Bill reduces Baskets to 2: General and Passive after 2006 PricewaterhouseCoopers Page 27 10/21/2004 FTC Formula: Separate Baskets Foreign Tax = Credit Limit PricewaterhouseCoopers Foreign Source Taxable Income Within Basket x World Wide Taxable Income US Tax Before FTC Page 28 10/21/2004 Foreign taxes are allocated to individual baskets. • Sec. 901, 902, and 960 taxes • Look to tax base on which tax is imposed and in which basket the income is included PricewaterhouseCoopers Page 29 10/21/2004 Ordering Rules • Apply to income (e.g. interest) which falls into more than one basket • All other separate baskets (except general limitation) take precedence over passive basket PricewaterhouseCoopers Page 30 10/21/2004 CFC Look-Through Rules • Characterize certain income received from CFCs based on CFC’s income rather than actual payment (e.g., dividend) • Applies to CFC’s U.S. shareholders - Subpart F income reported as constructive dividend - Dividends, interest, rent, and royalty payments received from a CFC PricewaterhouseCoopers Page 31 10/21/2004 FTC Example • Assume a U.S. corporation earns $100,000 in total taxable income (U.S. 1120) • Of this total, $50,000 is foreign source taxable income on which $20,000 of foreign taxes (direct and indirect) is paid • Consider the effect of the foreign source income being classified into two separate baskets versus a single basket PricewaterhouseCoopers Page 32 10/21/2004 FTC Example: Single Basket US 1120 Taxable Income U.S. Tax Liability Before FTCs $100,000 $34,000 Potential Foreign Tax Credits: Sec. 901/903 Direct Credits Sec. 902 Deemed Paid FTCs Total Potential FTCs FTC Limitation: Foreign Source Taxable Income / World-wide Taxable Income x U.S. IncomeTax before FTCs = FTC Limit (by basket) Allowed FTC (Lesser of Actual vs Limit) Residual (net) U.S. Income Tax Liability FTC Carryforwards PricewaterhouseCoopers ---US Source--50,000 --Foreign Source-General Limitation 50,000 5,000 15,000 20,000 50,000 100,000 34,000 17,000 (17,000) $17,000 3,000 17,000 3,000 Page 33 10/21/2004 FTC Example: Separate Baskets US 1120 Taxable Income U.S. Tax Liability Before FTCs $100,000 $34,000 Potential Foreign Tax Credits: Sec. 901/903 Direct Credits Sec. 902 Deemed Paid FTCs Total Potential FTCs FTC Limitation: Foreign Source Taxable Income / World-wide Taxable Income x U.S. IncomeTax before FTCs = FTC Limit (by basket) Allowed FTC (Lesser of Actual vs Limit) Residual (net) U.S. Income Tax Liability FTC Carryforwards PricewaterhouseCoopers (14,200) $19,800 5,800 ---US Source--50,000 -----Foreign Source----General Limitation Passive 30,000 20,000 1,000 15,000 16,000 4,000 4,000 30,000 100,000 34,000 10,200 20,000 100,000 34,000 6,800 10,200 4,000 5,800 - Page 34 10/21/2004 Losses and the FTC • Separate Limitation Loss Reclassification - Losses in separate basket allocated against foreign source income in other baskets before being allocated against U.S. source income - Foreign losses allocated proportionately to separate baskets - Recharacterization or recapture in proportion to prior loss allocation • Overall Foreign Loss - Overall foreign loss (after consideration of separate limitation loss reclassification) offsets U.S. source income in current year - The lower of a) The amount of foreign losses used to offset U.S. source income in a prior year or b) 50% of the current year’s net foreign source income is recaptured in subsequent years as U.S. source income • U.S. Source Loss - A U.S. source overall loss (to the extent that it does not exceed the foreign source separate limitations for such year) is allocated among such incomes on a proportionate basis. There is no recapture rule. After 2006, Page 35 recapture rule applies to domestic losses. PricewaterhouseCoopers 10/21/2004 Additional Foreign Tax Credit Limitations • Limitation on the creditability of oil and gas taxes (Sec. 907). • FTC is creditable up to 90% of AMT (Sec. 59(a)). No limit after 2004 • Holding period requirement to claim FTC related to dividends received PricewaterhouseCoopers Page 36 10/21/2004 Considerations in Utilizing FTC • Portion of taxable income from foreign sources (numerator) - Gross income sourced as foreign - Expenses allocated and apportioned to foreign source income • Foreign effective tax rate on foreign source taxable income - Blending of high- and low-tax income - Management of separate baskets • Local country foreign taxes (including withholding taxes) PricewaterhouseCoopers Page 37 10/21/2004 Spectrum of Foreign Tax Credit Considerations Foreign Taxes Foreign Withholding Taxes Tax rate on FSI FSI OFL Recapture PricewaterhouseCoopers Expense Allocation/ Apportionment Flow of FTC Page 38 10/21/2004
© Copyright 2026 Paperzz