U.S. Foreign Tax Credit An Overview

Transcription

1 U.S. Foreign Tax Credit An Overview

2 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 Page 2

3 US Taxation Assuming No FTC or Deduction for Foreign Taxes US Tax Return Foreign Country Tax Return US Source Income Foreign Source income Taxable Income US Income Tax $1, $1,600 x.35 $ 560 Foreign Source Income Taxable Income Foreign Income Tax $600 $600 x.30 $180 US Tax Foreign Tax Worldwide Tax Worldwide ETR $ $ % [$740/$1,600) Page 3

4 US Taxation With FTC US Tax Return Foreign Country Tax Return US Source Income Foreign Source income Taxable Income US Income Tax (before FTC) Less FTC US Income Tax (after FTC) $1, $1,600 x.35 $ $380 Foreign Source Income Taxable Income Foreign Income Tax $600 $600 x.30 $180 US Tax Foreign Tax Worldwide Tax Worldwide ETR $ $560 35% [$560/$1,600) Page 4

5 Foreign Tax Credit Overview Purpose: Types of FTC: Annual Election: Minimize double taxation Direct (Secs. 901 & 903) and Indirect (Sec. 902 & 960) FTC vs. deduction of foreign taxes Page 5

6 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 Page 6

7 FTC Limit Formula Foreign Foreign Source US Tax Tax = Taxable Income x Before FTC Credit World Wide Limit Taxable Income Allowed FTC is the lesser of: - Creditable Foreign Income Taxes, or - FTC Limit [See Form 1118] Page 7

8 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). Page 8

9 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 Page 9

10 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 Page 10

11 Allocate versus Apportion Example (Apportion) foreign source vs US source US Source Foreign Source (Allocate) classes of gross income Mfg Income Dividends Interest Royalties Rents Page 11

12 Allocation & Apportionment: General Methods Allowed (Reg ) Units Sold Gross Receipts Gross Income Cost of Goods Sold Profit Contribution Expenses Incurred Compensation Space Utilized Time Assets Any other reasonable method Page 12

13 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 Page 13

14 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 Page 14

15 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 Page 15

16 Types of Foreign Tax Credits Direct credit, 901 In lieu of credit, 903 Deemed paid credit, 902 and 960 Page 16

17 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 Page 17

18 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. Page 18

19 Deemed Paid FTC: Example US Corp 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) Foreign Branch 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

20 Deemed Paid FTC: Example (con t) $750 Dividend US Corp Foreign Sub 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

21 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 Page 21

22 Distributions from Post- 86 E&P Pooling concept (applied to each separate basket) Deemed paid credit formula: Dividends X Post- 86 Foreign = Foreign Taxes Credit/ Post- 86 E&P Pool 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$ Page 22

23 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. Page 23

24 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 Page 24

25 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 Sec. 263A Pension Adjustments per Sec. 404A Reserves Currency Gains & Losses Taxes Page 25

26 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) Page 26

27 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 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 Page 27

28 FTC Formula: Separate Baskets Foreign Foreign Source Tax = Taxable Income US Tax Credit Within Basket x Before FTC Limit World Wide Taxable Income Page 28

29 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 Page 29

30 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 Page 30

31 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 Page 31

32 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 Page 32

33 FTC Example: Single Basket --Foreign Source-- US US Source--- General Limitation Taxable Income $100,000 50,000 50,000 U.S. Tax Liability Before FTCs $34,000 Potential Foreign Tax Credits: Sec. 901/903 Direct Credits 5,000 Sec. 902 Deemed Paid FTCs 15,000 Total Potential FTCs 20,000 FTC Limitation: Foreign Source Taxable Income 50,000 / World-wide Taxable Income 100,000 x U.S. IncomeTax before FTCs 34,000 = FTC Limit (by basket) 17,000 Allowed FTC (Lesser of Actual vs Limit) (17,000) 17,000 Residual (net) U.S. Income Tax Liability $17,000 FTC Carryforwards 3,000 3,000 Page 33

34 FTC Example: Separate Baskets -----Foreign Source----- US US Source--- General Limitation Passive Taxable Income $100,000 50,000 30,000 20,000 U.S. Tax Liability Before FTCs $34,000 Potential Foreign Tax Credits: Sec. 901/903 Direct Credits 1,000 4,000 Sec. 902 Deemed Paid FTCs 15,000 Total Potential FTCs 16,000 4,000 FTC Limitation: Foreign Source Taxable Income 30,000 20,000 / World-wide Taxable Income 100, ,000 x U.S. IncomeTax before FTCs 34,000 34,000 = FTC Limit (by basket) 10,200 6,800 Allowed FTC (Lesser of Actual vs Limit) (14,200) 10,200 4,000 Residual (net) U.S. Income Tax Liability $19,800 FTC Carryforwards 5,800 5,800 - Page 34

35 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, recapture rule applies to domestic losses. Page 35

36 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 Page 36

37 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) Page 37

38 Spectrum of Foreign Tax Credit Considerations Foreign Taxes Foreign Withholding Taxes FSI Tax rate on FSI OFL Recapture Expense Allocation/ Apportionment Flow of FTC Page 38