U.S. Foreign Tax Credit An Overview

U.S. Foreign Tax Credit
An Overview
3Š&
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