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Indirect Foreign Tax Credit

Recall that the foreign tax credit is available to US persons for foreign income taxes paid on foreign source income

What if a US person owns an interest in a foreign corporation? The foreign corporation will pay foreign taxes

but not qualify for a FTC (since not a US person and not paying US tax)

When the foreign corporation pays a dividend to the US shareholder, such dividend is paid out of after (foreign) tax earnings!

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Deemed Paid Foreign Tax Credit

No dividends received deduction typically allowed for foreign source dividends

A US corporation receiving dividends from foreign corporations meeting certain ownership requirements Recognizes dividend income equal to the net

dividend received plus foreign taxes paid by the foreign corporation on the income from which the dividend is distributed

Claims a deemed paid credit for the above tax amounts, subject to FTC limitations

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Dividend Gross-up and Deemed Paid Foreign Taxes

Foreign taxes Post-1986 Dividend paid bydeemed = taxes of foreign X foreign corporation paid corporation Post-1986 undistributed

earnings of foreign corporation

Total dividend = Dividend + Foreign taxesincome paid deemed paid

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Example 1: Deemed Paid Foreign Taxes

Home Corporation receives a dividend of $1 million from Away, Inc., a 100% owned foreign corporation. Prior to the dividend payment, Away had $5 million of undistributed post-1986 earnings and had paid $2 million of foreign taxes. Compute Home’s deemed paid foreign taxes and total dividend income attributable to the payment from Away.

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Ownership Requirements

Not all foreign dividends bring with them ‘deemed paid’ foreign taxes US corporation must own at least 10% of the

voting stock of the foreign corporation For lower tier subsidiaries

• Must be connected through a chain of ownership in which each tier owns at least 10% of the lower tier

• US parent’s indirect ownership must be at least 5%• In 4th, 5th, and 6th tiers, must be a CFC of which the

US parent is a ‘US shareholder’• No deemed paid taxes beyond the 6th tier

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Example 2: Ownership and Deemed Paid Foreign Taxes

USA Inc., a US corporation, owns the following voting stock interests in foreign corporations: 50% interest in F1 20% interest in F2 100% interest in F3

F1 owns 25% of F4, F2 owns 50% of F5 and 20% of F6, and F3 owns 80% of F7

From which foreign corporations do deemed paid taxes flow through to USA?

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Dividend Baskets

Depending on the level of a US corporation’s ownership of a foreign corporation, 3 different basket rules may apply for purposes of the FTC limitation Passive income basket 10/50 basket(s) Look-through

For individuals, only the passive income and look-through basket rules apply

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Dividend Baskets continued

Passive income basket Dividends from foreign corporations not

meeting the ownership requirements for deemed paid foreign taxes

10/50 baskets Dividends from corporations with greater than

10% ownership not qualifying as ‘controlled foreign corporations’

Dividends from each 10/50 corporation are a separate basket for purposes of the FTC limitation

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Dividend Baskets continued

Look-through Dividends from ‘controlled foreign

corporations’ are placed in baskets by looking through to the underlying income character of the paying corporation

Controlled foreign corporation (CFC) Foreign corporation in which ‘US

shareholders’ own more than 50% of voting power or value of stock• ‘US shareholder’ is a US person owning 10% or

more of voting power or value

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Example 3: Dividend Baskets

Refer to example 2 Determine which of the corporations in which

USA owns an interest are considered ‘controlled foreign corporations’

For each corporation in which USA owns an interest, determine the dividend basket that applies in sourcing dividend payments• How would your basket designations change if

USA where an individual rather than a corporation?

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Example 4: CFC and Deferral of US Taxation

Micro Inc. is a US corporation conducting business abroad. Micro earned $1 million of foreign source income and $3 million of US source income. It paid $200,000 of foreign income taxes. If Micro conducts business abroad through a

branch office, calculate its US tax liability after FTC and total worldwide tax burden.

How would your answers change if Micro conducts business abroad using a foreign subsidiary?

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Example 4 continued

Suppose that Micro reinvests its foreign earnings (after tax) for 10 years. During this period, its earnings grow at a 10% rate per year. At the end of 10 years, it repatriates all of its after (foreign) tax foreign earnings. Quantify the value of the deferral of US taxation achieved through the use of a foreign corporation.

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Subpart F and Limits on Deferral

Subpart F imposes current taxation on certain tax haven income of CFCs US shareholders of CFCs are taxed as though

such income were currently repatriated Two targeted groups of CFCs:

• Foreign personal holding companies

• Foreign base companies

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Foreign Personal Holding Companies (FPHC)

Definition: Foreign corporation in which More than 50% of voting power or value of

stock is owned directly or indirectly by 5 or fewer US individuals, and

At least 60% of gross income is ‘foreign personal holding company income’• Passive investment income

• Securities and commodities gains

• Income from personal services performed by 25% or greater shareholders

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Example 5: FPHC

Ed, a US citizen with a 40% marginal tax rate, owns 100% of the stock of Comet Inc., a foreign corporation. Comet earned $200,000 of interest and dividend income, recognized $50,000 of securities gains, had active business income of $150,000, and paid $50,000 of foreign income tax (all related to its business income). Is Comet a FPHC? What are the US tax implications for Ed and

Comet?

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Foreign Base Companies

Concept: Tax haven base for recognizing profit that has been artificially shifted there from the jurisdiction of the underlying economic activity generating that profit

Foreign Base Company Income: Foreign personal holding company income Foreign base company sales income Foreign base company services income Foreign base company shipping income Foreign base company oil related income

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Foreign Base Company Sales Income

Income from the sale of personal property between related persons, where the property is Manufactured, produced, grown or extracted

outside the country in which the CFC is organized

For use, consumption, or disposition outside that country

Substantial value added in the CFC’s country removes the income from this category

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Foreign Base Company Services Income

Income from services performed for or on behalf of a related person outside the country in which the CFC is organized Does not include services actually performed

in the CFC’s country Does not include services related to the sale of

property produced by the CFC

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Subpart F Income and the FTC

Income subject to Subpart F is considered constructively repatriated Subject to ‘dividend gross up’ and ‘deemed

paid foreign tax’ rules Look-through rules apply in determining

income sourcing for FTC basket limitations• Some types of Subpart F income (passive income,

shipping income) are also subject to separate baskets for FTC purposes

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Example 6: Impact of Subpart F on Deferral

Refer to Example 4, in which Micro uses a foreign subsidiary to conduct operations earning $1 million and paying $200,000 of foreign tax. Micro has $3 million of US source income. If $600,000 of the foreign subsidiary’s

earnings are foreign base company sales income, calculate Micro’s US tax liability after FTC and total worldwide tax burden

How does Subpart F impact the long-term value to Micro of using a foreign subsidiary?

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Example 7: FPHC versus CFC with FPHC Income

Refer to Example 5, in which Ed owns 100% of Comet. How would your conclusions change if Comet’s owner were Ed Inc., a US corporation?