DEVELOPMENTS FILING DEADLINES

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1 CPE Credit Service Sidney Kess and Barbara Weltman FOCUS: Foreign Tax Credit PRACTICE MANAGEMENT TIP: Cultivating Millennials as Clients RECENT DEVELOPMENTS FILING DEADLINES and REMINDERS ONLINE GRADING INSTANT TEST SCORES AND NO EXPRESS GRADING FEE SEE PAGE 48 FOR DETAILS 4025 W. Peterson Ave. Chicago, IL CCHGroup.com

2 This publication is designed to provide accurate and authoritative in-formation in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service and that the authors are not offering such advice in this publication. If legal advice or other expert assistance is required, the services of a competent professional person should be sought CCH Incorporated and its affiliates. All rights reserved. No claim is made to original government works; however, within this Product or Publication, the following are subject to CCH Incorporated s copyright: (1) the gathering, compilation, and arrangement of such gov-ernment materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials. Printed in the United States of America

3 1 Introduction CPE CREDIT SERVICE July 2015 This CPE Course, developed by noted tax authorities Sidney Kess and Barbara Weltman, provides you with an overview of recent tax developments. This series reviews what is happening or is about to happen on the tax scene and highlights planning tips and techniques to help you in your practice. Citations to CCH s FEDERAL TAX GUIDE REPORTS (FTG), STANDARD FEDERAL TAX REPORTS (FED), and TAX RESEARCH CONSULTANT (TRC) are provided to assist you in locating information for further review. More importantly, however, a Quizzer is contained in the back of the Course and can be completed for CPE credit. When you have a thorough understanding of the material contained in this Course, answer the Quizzer questions. Go to CCHGroup.com/CPECredit to complete your Quizzer online for immediate results and no Express Grading Fee. Further information is provided in the CPE Quizzer instructions on page 48. Successful completion of the Quizzer should qualify you for four* hours of continuing education credit. See the Quizzer instructions on page 48 for complete details. Please note that CCH s CPE CREDIT SERVICE is mailed to CCH federal tax subscribers. Should you be a subscriber to several services, you will receive multiple copies of this month s CPE CREDIT SERVICE. Since the information is identical, please be advised that only one of these Courses can be completed for Continuing Professional Education credit. Go to CCHGroup.com/CPECredit to complete your Quizzer online for immediate results and no Express Grading Fee. Further information is provided in the CPE Quizzer instructions on page 48. * CPE requirements vary from state to state. Please contact your CPE governing body for information on the CPE credit that is accepted for self-study. July 2015 CCH CPE CREDIT SERVICE This Course material is designed to be used in conjunction with your CCH reporters. We refer you to the specific paragraphs in the reporters, where each subject is covered in greater detail. FTG paragraph ( ) numbers refer to the FEDERAL TAX GUIDE. FED paragraph ( ) numbers refer to the STANDARD FEDERAL TAX REPORTS. TRC topic identifiers and numbers refer to TAX RESEARCH CONSULTANT. Please see page 56 for the CPE Course Spotlight on the CCH Learning Center.

4 2 ABOUT THIS ISSUE This edition of the CPE CREDIT SERVICE focuses on the foreign tax credit for individuals and corporations. It looks at key provisions, developments, and potential changes on the horizon that will affect individuals and businesses. We will also provide those of you who are tax practitioners with a practice management tip. Further, we will tell you about some important cases, regulations, rulings, and other IRS pronouncements that can be useful for your clients and can help you in your practice or business. Finally, we will remind you of some key filing deadlines that are coming up.

5 Contents I. FOCUS: Foreign Tax Credit... 4 Learning Objectives... 4 A. Introduction... 4 B. Overview... 4 C. Details About the Foreign Tax Credit... 9 D. Form E. Form F. Credit vs. Deduction G. Special Issues H. Ancillary Issues I. Conclusion II. PRACTICE MANAGEMENT TIP: Cultivating Millennials as Clients Learning Objectives A. Introduction B. Tax Issues for Millennials C. Menu of Employee Benefits D. How to Communicate with Millennials E. Conclusion III. RECENT DEVELOPMENTS Learning Objectives A. Supreme Court Strikes Down State s Double Tax B. Developments Under the PAL Rules C. Modifications in EPCRP D. Deducting State Income Tax on Business Income E. HSAs for F. Trade or Business Expenses G. Workers Compensation H IRS Data Book I. Updated List of Private Delivery Services J. IRS Interest Rates for the Third Quarter of IV. FILING DEADLINES AND REMINDERS A. September 15, B. Looking Ahead Conclusion Answers to Study Questions CPE Quizzer Instructions Quizzer Questions Evaluation Form CCH Learning Center Answer Sheet

6 4 I. FOCUS: Foreign Tax Credit LEARNING OBJECTIVES Upon completion of this section, participants will be able to: List the types of creditable taxes Explain limitations on the foreign tax credit Discuss special rules for Forms 1116 and 1118 A. Introduction The focus of this edition of the CPE CREDIT SERVICE is on the foreign tax credit for individuals and corporations. The credit is intended to eliminate double taxation for citizens, residents, and domestic corporations that results from paying taxes abroad while being required to report worldwide income and pay taxes on this income in the United States. The foreign tax credit dates back to Individuals claimed $17.3 billion in foreign tax credits in 2012 (Spring 2015 Statistics of Income Bulletin); domestic corporations claimed $118.1 billion in foreign tax credits in 2010 (Fall 2014 Statistics of Income Bulletin). From a tax perspective, properly claiming and reporting the foreign tax credit by a U.S. citizen or resident individual or domestic corporation is highly complex. It requires an understanding not only of highly technical tax rules, but also of tax treaties with foreign countries and currency fluctuations. This course is designed to provide a basic understanding of the foreign tax credit and how to complete the forms for the tax credit that must be filed with tax returns. Because computers do the computations, this course covers what, where, and how to input required information and leaves the computations to technology. There are many nuances in foreign tax credit rules that are not covered in this course. More details can be found in IRS Publication 514, Foreign Tax Credit, as well as in the instructions to Form 1116 (for individuals, trusts, and estates) and Form 1118 (for C corporations). The following has been prepared with the help of Jerry August, a partner in the law firm of Kostelanetz& Fink, LLP ( in New York City. B. Overview The foreign tax credit is a dollar-for-dollar reduction against federal income taxes. There are two types of foreign tax credits: direct and indirect. Direct foreign tax credits. The foreign tax credit offers the opportunity for a dollar-for-dollar reduction in the U.S. federal income tax otherwise imposed on the overseas profits of U.S. multinational taxpayers and on overseas income of U.S. citizens and residents (Code Secs. 901, 902, 903, 904, 960). Although foreign income taxes are generally deductible against U.S. income (Code Sec. 164(a)(3)), the foreign tax credit is substantially more valuable in most cases than an income

7 tax deduction since the latter merely reduces the amount of foreign source income subject to tax instead of achieving a dollar-for-dollar offset. The United States also allows a foreign tax credit to foreign persons with respect to their income effectively connected with the conduct of a trade or business in the United States. There are applicable limitations imposed on the current use of foreign tax credits (see Code Sec. 904(d) and underlying regulations). In general terms, the credit is limited to income taxes (Code Sec. 901(a)), but may apply as well to a substitution tax (Code Sec. 903). A substitution tax is imposed instead of and not in addition to an income tax, even though not based on income. However, penalties, fines, interest, customs duties, and other military payments are not taxes for purposes of the foreign tax credit (Reg (a)(2)(i)). Moreover, a soak-up tax is not eligible for the credit (Reg (c)). A soak-up tax is a tax conditioned on the availability of a foreign tax credit to the taxpayer in the home jurisdiction. Sometimes it is difficult to distinguish between a tax and a royalty with respect to the production of oil or other natural resources. The credit applies only if the foreign government also obtains a royalty amount that is figured separately from the tax amount (Rev. Rul ). 5 PLANNING POINTER: No credit can be claimed for income taxes paid to a foreign country if it is reasonably certain that the taxes will be refunded, credited, rebated, abated, or foreign (even if this requires the taxpayer to make a claim for such recoupment). For instance, if a taxpayer works in a country that has a treaty with the U.S. permitting U.S. citizens and residents to pay reduced tax rates, the credit is figured on the treaty rate, not the actual rate, because the taxpayer is ultimately liable only for the treaty rate (i.e., any excess can be recouped). Who can claim the credit? The credit is available to U.S. citizens and residents as well as domestic corporations. For passthrough entities (partnerships, S corporations, trusts, and estates), the entity does not claim the credit; the amount of foreign taxes paid is passed through to owners who claim the credit on their personal returns. Mutual fund shareholders can claim their share of a foreign tax credit paid by the fund if the fund chooses to pass the credit on to them. A passed-through foreign tax credit is reported to mutual fund shareholders on Form 1099-DIV. Corporations owning subsidiaries and multiple tiers of ownership interests can raise problems for the foreign tax credit. For example, there are six ownership tiers allowed for which a foreign tax credit may be eligible (Code Sec. 902(b)). These complex issues are not covered in this program. Indirect foreign tax credits. A C corporation (but not an S corporation) can claim a deemed foreign tax credit for its share of foreign taxes actually paid by a foreign corporation provided the domestic corporation owns 10% or more of the voting stock of the foreign corporation at the time it receives a dividend from the foreign corporation (Code Sec. 902). In such instance, it is treated as having paid the same proportion of the foreign corporation s post-1985 foreign income taxes

8 6 as (i) the amount of such dividends (determined without regard to Code Sec. 78), bears to (ii) such foreign corporation s post-1986 undistributed earnings. The basic principle of the indirect tax credit is that it should not be more or less advantageous from a U.S. federal income tax perspective to operate abroad through a subsidiary than through a branch. Thus, the profit of a foreign subsidiary in the hands of its domestic parent corporation should have been subject to the same total tax burden that the profit from the same operation conducted as a branch would be. The domestic corporation operating as a branch would receive a direct foreign tax credit for the foreign income taxes the parent paid on the branch income. Equal treatment for the branch and the subsidiary requires that the parent receive an indirect credit for the subsidiary s own income taxes paid. The domestic corporate shareholder is entitled to a credit against domestic income tax for the foreign income tax paid by the foreign subsidiary (Code Sec. 902). The amount of foreign taxes paid by the payor is included in the shareholder s gross income (the gross-up ) in order to ensure that the same amount of tax is paid as would be the case if the income were earned by a U.S. (or foreign) branch of the recipient shareholder (Code Sec. 78). Example of indirect foreign tax credit. USCO, which is subject to U.S. income taxation at a rate of 35%, owns 25% of the outstanding stock of Forco; the balance of Forco s stock is owned by third-country residents unrelated to USCO. Forco earns $500x of income in its home country and bears a 20% local tax on that income. Forco then distributes its remaining $400x of earnings to its shareholders, net of a 10% withholding tax; USCO receives cash of $90x ($400x - $40 withholding tax = $360x; $360x * 25% = $90x). The tentative U.S. tax on the dividend is $35x ($90x cash * 35% = $25x, plus $10x withholding tax), which (before application of the indirect credit) would be offset by a foreign tax credit of $10x for the withholding tax on USCO s share of the distribution, yielding a final U.S. tax of $25. USCO is also entitled to an indirect credit for its pro rata share of Forco s foreign income tax paid with respect to the distributed income ($100x * 25% = $25x). If USCO had earned $125x directly from U.S. sources, its total tax would equal the U.S. tax burden of $43.75x ($125x * 35%). If USCO were deemed to have earned only $100x from Forco, its U.S. tax burden would be $0x ($100x * 35% = $35x, reduced by a direct credit of $10x and an indirect credit of $25x) and its aggregate burden would only be $35x (the sum of the two foreign taxes). By including the amount of the indirect foreign tax in USCO s income as a dividend, the U.S. burden increases to $8.75x ($125x * 35% = $43.75x, reduced by $35x of direct and indirect foreign tax credit), and USCO s aggregate tax burden rises to $43.75x - the amount USCO would have owed if all of the income were from U.S. sources and free of foreign tax. Deemed foreign tax credits are permitted to corporate and individual shareholders with respect to their share of a controlled foreign corporation s foreign taxes paid or accrued (see Code Secs. 960 and 962). Which foreign taxes are eligible for foreign tax credits? As in the case of domestic taxes, not every foreign tax qualifies for the foreign tax credit. Qualified foreign taxes include the following items paid or accrued (Reg (a)(1)): Income taxes. This is a tax for which a taxpayer gets no specific economic benefit and has the same predominant character of the tax that is an income tax in the U.S. sense. Income taxes include taxes paid to a foreign

9 country or subdivision (e.g., province) in lieu of income taxes, such as withholding taxes. Income taxes do not include taxes on excluded income; taxes that can only be taken as an itemized deduction; taxes on foreign mineral income; taxes from international boycott operations; a portion of taxes on combined foreign oil and gas income; taxes of U.S. shareholders controlling foreign corporations, subject to a special election under Code Sec. 902, and partnerships that fail to file required information returns; and taxes related to a foreign tax splitting event (e.g., a parent corporation paying taxes on income earned by a subsidiary, a splitting event barred under Code Sec. 909). 7 PLANNING POINTER: Pension, unemployment, and disability fund payments are not treated as payment for a specific economic benefit if the amount does not depend on age, life expectancy, or other characteristics of the individual taxpayer. Therefore, foreign tax credits may be claimed on a foreign country s imposing income tax or in lieu of tax under Sec. 903 on amounts constituting income with respect to such retirement or disability payments. However, no credit can be taken for social security taxes paid to a foreign country if the U.S. has a social security agreement. Determinations about whether a foreign tax is an income tax are made for each country involved. Excess profits taxes. This category, which is a type of income tax, includes taxes paid on profits over a set amount. These taxes typically are imposed on businesses during times of emergency (e.g., during war). War profits taxes. This category, which is also a type of income tax, includes taxes typically imposed during times of war, usually on manufacturers of armaments. No foreign tax is allowed for any income, war profits, or excess profits tax to the extent the amount of such tax is used, directly or indirectly, by the country imposing such tax to provide a subsidiary by any means to the taxpayer or a related person and such subsidiary is determined by reference to the amount of such tax (Code Sec. 901(i) and Reg (f) for taxes against which credit is not allowed). In addition to being an income tax, the payment of the tax must be compulsory (Reg (e)(5)). This means that if the foreign tax is partially refundable, only the nonrefundable portion is creditable. This is so whether or not the taxpayer makes a claim for a refund. Foreign taxes that do not fall within one of these three categories do not qualify for the foreign tax credit. For example, real property taxes paid on foreign realty do not qualify for the foreign tax credit. However, these other taxes may be deductible (and not creditable) if incurred in a trade or business or for the production of property. This is so even if the taxpayer elects to take a foreign tax credit for foreign income taxes.

10 8 PLANNING POINTER: For purposes of the foreign tax credit, taxes paid to U.S. possessions are treated as foreign taxes. These include taxes paid to such U.S. possessions as Puerto Rico and American Samoa. Other types of taxes not treated as creditable (i.e., eligible for the credit) include a VAT, excise tax, or tax on net worth. Foreign taxes for which a credit cannot be taken. Even if a tax is allowed within a category for a qualified foreign tax, no credit can be taken for the following: The tax is paid to a country for which a credit is not allowed because it provides support for acts of international terrorism, or because the United States does not have or does not conduct diplomatic relations with it or recognize its government and that government is not otherwise eligible to purchase defense articles or services under the Arms Export Control Act. Currently, the list of countries for which a foreign tax credit cannot be taken include Iran, North Korea, Sudan, and Syria (see Publication 514). Cuba was removed from the list in May 2015 (it is still in the current version of Publication 514). Note: Taxes that are noncreditable for political reasons may still be deductible under Code Sec. 164(a), assuming they are not illegal payments barred under Code Sec. 162(c). Withholding tax is paid on dividends from foreign corporations where the stock has not been held for the required period of time. For dividends on common stock, the minimum holding period is 15 days during the 31-day period beginning on the date that is 15 days before the date on which the right to receive payment arises. For dividends on preferred stock, there is a 45-day holding period requirement within a 91-day period. Withholding tax is paid on income or gain (other than dividends) from property that the taxpayer did not hold for the required period of time. Withholding tax on income or gain to the extent the taxpayer had to make related payments on positions in substantially similar or related property. Taxes paid by an individual who participated in or cooperated with an international boycott. Taxes in connection with the purchase or sale of oil or gas. Taxes paid or accrued on income or gain in connection with a covered asset acquisition. Covered asset acquisitions include certain acquisitions that result in a stepped-up basis for U.S. tax purposes. Note: Sec. 901(m) was added to the Internal Revenue Code in 2010 to reduce the foreign tax credit otherwise allowable after a covered asset acquisition of overseas assets in which there is a step-up in the tax bases of those assets for U.S. tax purposes but not for foreign tax purposes such as involving an election under Code Sec. 338(g). Amounts eligible for refund for which the taxpayer does not apply.

11 9 EXAMPLE: A taxpayer has $1,000 withheld on income of which $600 can be recouped under a tax treaty. The taxpayer does not apply for a refund. The foreign tax credit is limited to $400. Study Questions 1. All of the following may claim a foreign tax credit except: a. Partner b. Shareholder in a mutual fund that passes the credit through c. S corporation d. C corporation 2. Which of the following is not eligible for the foreign tax credit? a. Social Security taxes b. Income taxes c. Excess profits taxes d. War profits taxes 3. Which of the following is a creditable tax for the foreign tax credit? a. Income taxes paid to a country supporting terrorism. b. Tax on dividends paid on stock held 10 days. c. Income taxes paid to Puerto Rico. d. Taxes paid in connection with the sale of oil. C. Details About the Foreign Tax Credit Knowing who can claim the credit and which taxes are creditable is only the first step in figuring the amount of the credit. Additional factors include the taxpayer s method of accounting, the limitations on the foreign tax credit, and foreign currency rules. Impact of accounting method. The taxpayer s accounting method determines the year in which a foreign tax credit is claimed. Cash method taxpayers. A foreign tax credit can be claimed for the year in which the foreign tax is paid or accrued (Code Sec. 905(a)). (Accrual occurs in the year in which all the events have taken place to fix the amount of the tax and the liability to pay it.) The choice by an individual is indicated on Form 1116 by checking the box in Part II. Once the choice of claiming the credit in the year of accrual is made, it applies for all foreign taxes (e.g., the taxpayer cannot claim the credit for some based on actual payment and others based on accrual) and for all future years. Moreover, if the option is chosen, then only the credit (and not the deduction) can be claimed for accrual years. If, after accrual, there is a change in the foreign tax, the taxpayer must make an adjustment in the credit (discussed later in this course) (Code Sec. 905(c)).

12 10 Accrual basis taxpayers. A foreign tax credit is claimed only in the year in which the foreign tax is accrued. Proof of payment. A taxpayer generally must have receipts showing the actual payment of the foreign tax (Reg (a)(2)). Limit on the foreign tax credit. Generally, the foreign tax credit cannot exceed a taxpayer s tax liability for the year. For individuals, the foreign tax credit is the smaller of the amount of foreign taxes paid or the regular tax, which includes the alternative minimum tax and the excess advance premium tax credit repayment (for those who claimed too much of a credit when purchasing health coverage through a government exchange). For C corporations, the foreign tax credit is limited to a direct foreign tax credit (Code Sec. 901(b)(5)). Where a domestic corporation owns 10% or more of the stock of a foreign corporation, the domestic corporate shareholder can claim a foreign tax credit against domestic income tax for the foreign income tax paid by the foreign subsidiary (Code Sec. 902). The amount of foreign taxes paid by the foreign corporation is grossed-up and included in the domestic corporation s gross income to ensure that the same amount of tax is paid as would be the case if the income were directly earned by a U.S. or foreign branch of the domestic shareholder (Code Sec. 78; see also Code Sec. 960). The alternative minimum tax has separate provisions pertaining to the use of foreign tax credits to both corporate and noncorporate taxpayers (see Code Secs. 55(b)(1)(A)(i), 55(b)(1)(B)(ii), 59(a)(1)). The amount of the foreign tax credit in excess of this limitation is not lost. Instead, it becomes a carryover that can be carried back and forward for a set period. The same carryover periods apply to individuals and C corporations (Code Sec. 904(c)). PLANNING POINTER: The foreign tax credit is not part of the general business credit and its limitations. Carrybacks and carryovers. The carryback period is one year; the carryforward is 10 years (Code Sec. 904(c)). Unlike the carryback for a net operating loss, the taxpayer cannot choose to forego the carryback and simply use the carryforward. PLANNING POINTER: A carryback or carryover cannot be used in any year in which the taxpayer opts to deduct foreign taxes rather than taking a foreign tax credit (see Credit vs. Deduction later in the course). The carryover period is not extended even though a taxpayer is unable to use it because of having made the election to claim the deduction in a particular year. Foreign currency and exchange rates. U.S. income tax is reported in U.S. currency. Therefore, in most cases taxpayers with a foreign tax (obviously paid in

13 foreign currency) have to convert the amount into U.S. dollars. Exchange rates are readily available from banks, U.S. embassies, and online resources. 11 PLANNING POINTER: There is a special rule that allows reporting in a functional currency rather than in the U.S. dollar. Functional currency is the primary type of money used to conduct business. Functional currency can only be used by a qualified business unit, which can include a self-employed person in a foreign country (Code Secs. 988(a)(1) and 988(a)(3)(B)(iii)). This rule is not described further in this program; details can be found in IRS Publication 514. Timing the conversion of all items (income, expenses) received, paid, or accrued in a foreign currency becomes critical. The conversion is made on the date that the foreign taxes are paid to the foreign country (Code Sec. 986(a)(2)(A)). If the tax was withheld, then the date of withholding is the conversion date. If a refund of foreign taxes is received, the conversion rate is the rate in effect when the taxes were paid, not when the refund was received. Special rule for accrual basis. Cash basis taxpayers who choose to account for foreign income taxes on an accrual basis as well as accrual basis taxpayers must use the average exchange rate for the year to which the taxes relate if all of the following conditions are met (Code Sec. 986(a)(1)(A)): The foreign taxes are paid on or after the first day of the tax year to which they relate. The foreign taxes are paid not later than 2 years after the close of the tax year to which they relate. The foreign tax liability is not denominated in an inflationary currency (defined below). However, such taxpayers can elect to use the exchange rate in effect on the date the foreign taxes are paid if the taxes are denominated in a nonfunctional foreign currency. An inflationary currency. Inflationary currency is defined under the regulations as the currency of a country in which there is cumulative inflation during the 36 calendar months immediately preceding the last day of the tax year of at least 30%, as determined by reference to the Consumer Price Index (CPI) of the country listed in the monthly issues of International Financial Statistics, or a successor publication, of the International Monetary Fund. Study Questions 4. An individual s foreign tax credit exceeds the limitation. What is the result? a. The excess credit is lost forever. b. The excess can be carried forward for 10 years (no carryback). c. The excess can be carried back for one year and then forward for 10 years. d. The excess can be carried back for one year unless the taxpayer elects to merely carry the excess forward for 10 years.

14 12 5. Which statement about foreign currencies and exchange rates for purposes of the foreign tax credit is not correct? a. Usually, foreign taxes must be converted into U.S. dollars to figure the foreign tax credit. b. A functional currency (instead of the U.S. dollar) can be used by a qualified business unit. c. If the tax was withheld, then the date of withholding is the conversion date. d. Except for withholding, conversion of a foreign currency into U.S. dollars is made on the date of filing the income tax return. D. Form 1116 Computing the foreign tax credit is a complicated matter. The foreign tax credit is figured on Form 1116, Foreign Tax Credit, unless a taxpayer qualifies for direct reporting under a de minimis rule (explained below). Form 1116 is used by individuals, trusts, and estates. C corporations use Form 1118, explained later in this course. If any taxes are paid to the U.S. Virgin Islands, use Form 8689 and not Form 1116 for these taxes. Interestingly, the IRS says it should take on average two hours and 43 minutes for recordkeeping for Form 1116, one hour and one minute to learn about the law or the form, one hour and 42 minutes to prepare the form, and 34 minutes to copy, assemble, and send the form to the IRS. After reviewing the following information, it would seem that the IRS has severely understated the time needed to learn about the law or the form and prepare the form. Overview of the form. The form is comprised of four parts: Part I is for reporting taxable income or loss from sources outside the U.S. There are three columns available to report foreign source income from three foreign countries or U.S. possessions. Similarly this part is used for reporting deductions and losses. The net amount of foreign source income (gross income minus deductions and losses) is shown on the last line in this part of the form. Part II is for reporting foreign taxes paid or accrued. Here the taxes are shown in foreign currency and U.S. dollars withheld at the source for each type of income (dividends, rents and royalties, interest, and other foreign taxes paid or accrued).the total amount of foreign taxes paid or accrued is then entered on the last line in this part of the form. Part III is used for figuring the foreign tax credit. In general terms, this is the credit amount from Part II, increased by any carryback or carryover, adjusted for a reduction in foreign taxes, and subjected to the credit limitation. Part IV is the summary of credits from Part III for each income category (e.g., credit for taxes on passive category income, credit for taxes on general category income). Remember that separate Forms 1116 are used for each category.

15 When Form 1116 is not required. Some individuals may not have to complete Form 1116 and make all the complicated adjustments and computations that go with the form. However, in any year for which an election is made to report foreign taxes directly on the return (and not complete Form 1116), no carryovers are allowed to or from any other year. Individuals can elect to report foreign tax credits directly on their personal returns (line 48 of the 2014 Form 1040) if they qualify, which means individuals that pay less than $300 of foreign taxes, or $600 in the case of a joint return (Code Sec. 904(j)). The election is made simply by entering the foreign tax credit amount directly on the return. To qualify for the election, all of the following conditions must be met: 1. All foreign-source gross income is from interest and dividends and all of that income and the foreign tax paid on it were reported on Form 1099-INT, Form 1099-DIV, or Schedule K-1 (or substitute statement). 2. The total of foreign taxes is not more than $300 (not more than $600 if married filing jointly). 3. The stock or bonds on which the dividends or interest were paid were held for at least 16 days and the taxpayer was not obligated to pay these amounts to someone else. 4. The taxpayer does not file Form 4563, Exclusion of Income for Bona Fide Residents of American Samoa, or exclude income from sources within Puerto Rico. 5. All foreign taxes were legally owed and not eligible for a refund or reduced tax rate under a tax treaty, and were paid to countries that are recognized by the U.S. and do not support terrorism. Again, the foreign tax credit is the smaller of the amount of foreign taxes paid or the regular tax, which includes the alternative minimum tax and the excess advance premium tax credit repayment (for those who claimed too much of a credit when purchasing health coverage through a government exchange). Foreign sourced income. Foreign sourced income includes: Compensation for services performed outside the U.S. Interest income from a payer located outside the U.S. Dividends from a corporation incorporated outside the U.S. Gain on the sale of nondepreciable personal property sold while maintaining a tax home outside the U.S., if the tax is at least 10% of the gain to a foreign country. The credit is figured separately for each category of foreign sourced income (and a separate Form 1116 must be used for each): (a) Passive category income (e.g., dividends, interest, rents and royalties, annuities, net gains from non-income producing property the excess of gains over losses from foreign currencies, capital gains not related to the active conduct of a trade or business). 13

16 14 (b) General category income (e.g., wages, salary, and overseas allowances; income earned in the active conduct of a trade or business; gains from the sale of inventory or depreciable property used in a trade or business). Note: Passive activity income is treated as general category income if foreign taxes paid on the income exceed the highest U.S. tax that can be imposed on such income. PLANNING POINTER: Less-than-10% limited partners and certain lessthan-10% S corporation shareholders generally can treat their distributive share of foreign source income as passive category income rather than as general category income. (c) Code Sec. 901(j) income (e.g., income from sanctioned countries, which are those designated by the U.S. Secretary of State as repeatedly providing support for acts of international terrorism) (d) Certain income re-sourced by treaty (e.g., U.S.-source income treated as foreign-source income by a treaty) (e) Lump-sum distributions (e.g., distributions from a foreign pension plan) Partners and S corporation shareholders. Schedule K-1 provides information to these business owners about foreign-source income and foreign taxes paid on line 16. Here is a list of Codes used to explain entries on line 16 (and where to report items on Form 1116): Code Item Where to report the item on Form 1116 A Name of foreign country or U.S. possession Part I B Gross income from all sources Part I C Gross income sourced at owner level Part I D Passive category sourced at entity level Part I E General category sourced at entity level Part I F Other sourced at entity level Part I G Interest expense allocated and apportioned at owner Part I level H Other deductions allocated and apportioned at owner Part I level I Passive category deductions allocated and Part I apportioned at owner level to foreign source income J General category deductions allocated and Part I apportioned at owner level to foreign source income K Other deductions allocated and apportioned at owner Part I level to foreign source income

17 15 Code Item Where to report the item on Form 1116 L Total foreign taxes paid Part II M Total foreign taxes accrued Part II N Reduction in taxes available for credit Line 12 O Foreign trading gross receipts Form 8873 P Extraterritorial income exclusion Form 8873 Q Other foreign transactions Instructions from entity However, even though the income is apportioned to the categories, owners must nevertheless determine whether the income is U.S.-source income or foreign income for them personally, based on their tax home. Special adjustments for foreign-source qualified dividends and gains. Individuals who receive foreign-source qualified dividends (amounts reported on line 9b of Form 1040) and/or capital gains (including long-term capital gains, unrecaptured Section 1250 gain, and/or Section 1231 gains) (generally amounts reported on Form 8949 and Schedule D of Form 1040) that are taxed in the U.S. at a reduced tax rate (0% for those in the 10% or 15% bracket, 20% for those in the 39.6% bracket, and 15% those in any other bracket) may be required to adjust the foreign-source income that is reported on Form 1116, line 1a. Unless the adjustment exception (below) applies, then adjustments must be made to foreignsource qualified dividends and net capital gains. Dividends. The following adjustment applies to foreign-source qualified dividends: If the foreign-sourced income is taxed at the 0% rate, then the income is fully excluded from foreign source income (Form 1116, line 1a). If the foreign-sourced income is taxed at the 15% rate, then multiply that foreign-sourced income by and include only that amount in foreign-source income on Form 1116, line 1a. Foreign-sourced income multiplied by is the excludable portion. If the foreign-sourced income is taxed at the 20% rate, then multiply that foreign-sourced income by and include only that amount in foreign source income on Form 1116, line 1a. Foreign sourced income multiplied by is the excludable portion. PLANNING POINTER: No adjustment is required for any foreign-source qualified dividends that the taxpayer elects to report on Form 4962, Investment Interest Expense Deductions. Individuals can elect not to adjust foreign-sourced qualified dividends if:

18 16 The amount of foreign-source capital gain distributions, plus foreignsource qualified dividends, is less than $20,000 Their taxable income (with certain adjustments) puts them in a tax bracket over 28% (i.e., the 33%, 35%, or 36.9% tax bracket) The election is made simply by not making any adjustment. Trusts and estates can elect not to adjust foreign-sourced qualified dividends if: The amount of foreign-source qualified dividends is less than $20,000 Their taxable income (with certain adjustments) puts them in the 33% or 36.9% tax bracket Capital gains. Like foreign-source qualified dividends, adjustments may have to be made to foreign-source capital gains. Generally, the same conditions apply for taxpayers in opting not to make adjustments. However, if the taxpayers do not qualify, or qualify but do not make the election, then adjustments are required. This means making adjustments to foreign capital gains and losses using worksheets in the instructions to Form 1116 or following the instructions in Publication 514. The adjustments are made after long-term capital gains are reduced by any amount included on Form Use Worksheet A if foreign source capital gains and losses are in no more than two categories, the taxpayer qualifies for the adjustment exception, and federal income taxes are figured using the Qualified Dividends and Capital Gain Tax Worksheet (Form 1040) (certain specific requirements with respect to amounts on this worksheet can be found in the instructions to Form 1116). Use Worksheet B if the taxpayer does not qualify to use Worksheet A. Note that Worksheet B has two of its own worksheets that need to be completed in order to fill in Worksheet B. PLANNING POINTER: A single worksheet (either A or B) is used even if capital gains or losses are in two categories. The worksheet is not filed with the return; it is retained with the taxpayer s records. Capital losses. In determining U.S.-source income, capital losses must be reduced by the U.S. capital loss adjustment (the amount entered on line 4 of Worksheet A or line 2 of Worksheet B). This U.S. loss adjustment is an adjustment of foreign-source capital gains to the extent they exceed the amount of worldwide capital gains. If foreign-source capital gains do not exceed foreign-source capital losses, there are no foreign-source capital gains so no U.S. capital loss adjustment is needed. The following example illustrating the capital loss adjustment is adapted from the instructions to Form 1116: EXAMPLE: For 2015, an individual completed three Forms The first had a loss from general category income of $2,000 on line 15, the second had passive category income of $4,000 on line 15, and the third had income of $1,000 from the certain income re-sourced by treaty category on line 15. The taxpayer must allocate the $2,000 loss between the passive category income

19 17 and the certain income re-sourced by treaty category in the same proportion as each category s income bears to the total foreign income. The amount of the loss that would reduce passive category income would be 80% ($4,000/$5,000) of the $2,000 loss or $1,600. Include the $1,600 (in parentheses) on line 16 of the passive category income Form Assuming the taxpayer has no other line 16 adjustments, enter $2,400 ($4,000 - $1,600) on line 17 of that form. The amount of the loss that would reduce the certain income re-sourced by treaty would be 20% ($1,000/$5,000) of the $2,000 loss or $400. Include the $400 (in parentheses) on line 16 of the certain income re-sourced by treaty Form Assuming the taxpayer has no other line 16 adjustments, enter $600 ($1,000 - $400) on line 17 of that form. In this case, all of the $2,000 loss was allocated between the foreign-source passive category income and the certain income re-sourced by treaty category, and no reduction was made to U.S.-source income. If the taxpayer receives general category income in a later year, the taxpayer must recharacterize all or part of that income as passive category income and certain income re-sourced by treaty in that later year. Interest expense. An interest expense must be apportioned between the U.S.- and foreign-source income using an asset method (Reg ). An allocation is required even if the money is borrowed in the U.S. All interest must be apportioned, including mortgage interest, business interest, investment interest expense, and passive activity interest. Interest expense passed through from an S corporation (line 15g of Schedule K-1) or a partnership (line 12g of Schedule K-1) must also be apportioned (see Publication 514). However, under a de minimis exception to the interest apportionment rule, no apportionment is required if gross foreign-source income (including any foreign earned income exclusion or excludable foreign housing) does not exceed $5,000. In this case, all of the interest expense can be apportioned to U.S.-source income. Interest expense that has been apportioned to foreign-source income is reported on Form 1116, lines 4a and 4b. PLANNING POINTER: Charitable contributions have no impact on the foreign tax credit. They need not be apportioned and are not reported on Form The amount of foreign tax that qualifies as a credit is not necessarily the amount of tax withheld by the foreign country. If a taxpayer is entitled to a reduced rate of foreign tax based on an income tax treaty between the U.S. and a foreign country, only that reduced tax qualifies for the credit. Include on Form 1116 line 8 only the amount of creditable taxes. Amounts for which the taxpayer is not legally liable (such as taxes in excess of the treaty rate) are excluded from the amount reported on line 8. E. Form 1118 Corporations figure the foreign tax credit on Form 1118, Foreign Tax Credit- Corporations. This 11-page form requires much more extensive information than

20 18 asked of individuals on Form The corporate form is comprised of Schedules A through H. The following is intended to provide an overview of the corporate form. Schedule A is for reporting income or loss from sources outside the U.S. before making any adjustments. The schedule has space for reporting income from six countries or U.S. possessions (show the name of the country by using the two-letter code at sionals/e-file-providers-&-partners/foreign-country-code-listing-for- Modernized-e-File). It is also used to list deductions related to income (e.g., rental, royalty, and licensing expenses). Schedule B is for reporting foreign tax credits paid, accrued, or deemed paid. These credits fall within tax withheld at the source on certain types of income (e.g., dividends, interest) and other foreign taxes. Schedule C is used to figure the tax deemed to be paid by a corporation with respect to dividends from a foreign corporation. Schedule D is used to report the tax that is deemed to have been paid by a first-tier foreign corporation with respect to dividends from a second-tier foreign corporation. As mentioned earlier, six tiers are permissible for purposes of the foreign tax credit for corporations. Keep in mind that tier one is the parent corporation; the second tier is its subsidiary. The third tier is the subsidiary of second tier, and so on. Schedule E is used to report the tax that is deemed to have been paid with respect to dividends from a fourth-, fifth-, and sixth-tier controlled foreign corporation. Schedule F is used only by corporations with foreign branches to report gross income and definitely allocable deductions. Schedule G is for reporting reductions of taxes paid, accrued, or deemed paid. Schedule H is for apportioning deductions that are not definitely allocable. Part I is for research and development deductions; Part II is for interest deduction, all other deductions, and total deductions. F. Credit vs. Deduction Taxpayers can choose to take a deduction for foreign taxes instead of claiming a tax credit. The decision is made annually. Thus, claiming a credit one year does not preclude the decision to take the deduction in the next year. If the deduction option is chosen, then all foreign taxes that would otherwise be creditable must be deducted (e.g., a taxpayer cannot choose to deduct some taxes and claim a credit for others). If a taxpayer elects to take the deduction, the election is made simply by deducting the tax on Schedule A of Form 1040 for individuals or on the line on Form 1120 for C corporations for taxes and licenses (line 17 of the 2014 Form 1120).

21 19 PLANNING POINTER: The only way to know whether it is better to take the credit or the deduction is to figure the income tax both ways and choose the better option. Factors in taking the credit or deduction. For individuals, the deduction for foreign taxes paid with respect to property held for investment or the production of income (as compared with foreign taxes paid with respect to the carrying on of a trade or business) is an itemized deduction. As such, the deduction is: Allowed only for individuals who itemize personal deductions Subject to the phase-out of itemized deductions on high-income taxpayers Not deductible for alternative minimum tax purposes It is usually better to take the credit rather than the deduction because the credit reduces taxes dollar for dollar, while the deduction s benefit is limited to the taxpayer s tax bracket. For example, a $1,000 tax credit saves $1,000 in taxes, while a deduction saves only $250 in taxes if the taxpayer is in the 25% tax bracket. However, it usually is easier to figure the deduction (which is the amount of foreign taxes paid) versus the credit (which requires additional reporting unless eligible for simplified reporting). PLANNING POINTER: For corporations that opt to take the deduction instead of the credit and complete Form 1118, the amount of the credit is added back as an adjustment on Schedule M of Form For passthrough entities, the decision of whether to take a credit or a deduction is made by the owners, not by the entity. The amount of foreign taxes is passed through to owners. The amount of foreign taxes is reported on Schedule K as follows: For partners: Line 16, Codes A through Q. For S corporation shareholders: Line 14, Codes A through Q. For beneficiaries of trusts and estates: Line 14, Code B. Changing an election. The taxpayer s choice of a claiming a credit or deduction for foreign taxes can be changed during a 10-year period that starts on the due date of the return for which the choice relates (without regard to any extensions). This flexibility is sourced from Code Sec. 901(a) which provides in relevant part, [S]uch choice for any taxable year may be made or changed at any time before the expiration of the period... for making a claim for credit or refund... for such taxable year (see e.g., Chrysler Corporation, CA-6, 536 F.3d 644 (2006)). The change is made by filing an amended return. EXAMPLE: A taxpayer has been deducting foreign income taxes on her return for the past 12 years. In February 2015, she can file an amended return for 2004 (the due date of which was April 15, 2005) and choose to take the credit. If the credit for 2004 is limited, the carryback can only be claimed for a year within

22 20 the 10-year amendment period. Because the 2002 and 2003 years are earlier than the 10-year period, no carryback is allowed in this case. Study Questions 6. Which type of foreign-sourced income is not treated as passive income? a. Annuities b. Rents and royalties c. Interest d. Overseas allowances 7. Which of the following factors make it more favorable for an individual to take a deduction for foreign taxes rather than a credit? a. AMT write-off b. Ease of reporting c. Phase-outs for high-income taxpayers d. Itemizing required 8. Which of the following statements regarding the election by individuals to take a deduction rather than a credit for foreign taxes is not correct? a. No separate form or schedule is required. b. There is a 10-year period in which to change an election. c. The election is made by a passthrough entity. d. A change in an election requires an amended return. G. Special Issues Alternative minimum tax. The foreign tax credit can be used to offset the alternative minimum tax (AMT) with certain limitations. Individuals. The foreign tax credit is used to reduce the tentative AMT. Usually this requires individuals to figure the alternative minimum tax foreign tax credit (AMTFTC). However, those who did not file Form 1116 and instead reported the foreign tax credit directly on Form 1040 use this amount as the AMTFTC. Corporations. Corporations subject to the AMT must figure the alternative minimum tax foreign tax credit (AMTFTC). This is done by completing Form 1118 for AMT purposes and making certain adjustments. Corporations can elect to use a simplified Section 904 limitation to figure the AMTFTC. If the election is made, the corporation uses its separate limitation income or loss determined for regular tax instead of refiguring the separate limitation income or loss for the AMT. They must make the election for the first tax year beginning after 1997 for which an AMTFTC is claimed. If a corporation did not make the election for that tax year, it may not make the election for a later tax year. Once made, the election applies to all later tax years and may only be revoked with IRS consent.