Foreign Tax CreditTx 8300

Learning Objectives

1. Identify characteristics of a _________ tax,

2. Determine a DC’s ______ paid credit,

3. Calculate the foreign tax credit _________,

4. Explain the function of FTC _______,

5. Compute a U.S. person’s ____ from outbound investments, and

6. Explain tax _______.

You should be able to:

Dealing with Double Tax

• ___________ systems exempt FSI.

• ______ systems allow FTC.

• ______ systems exempt some income and otherwise allow the FTC.

• ________ often modify how these systems address double tax problems.

Basic Choices in U.S.

• Deduct:– Foreign ______ tax, §164(a)(3)– Any foreign ___ of trade or business, §162(a)– Any foreign ___ of investment activity, §212(1)

• Credit foreign income tax, §901(a)– Annual _________– _____ return to change election

Creditable Foreign Levies

• Must be a ___ and

• Either:– Its ___________ character is

that of income tax in ____ sense or

– It ___________ for generally-imposed income tax

What Is a Tax?

• __________ transfer– Excludes payments > ____ foreign tax liability– Must exhaust all practical ________

• Pursuant to government’s ______ authority– Excludes _____, penalties, interest, custom

duties, and compulsory _____– Excludes levies for specific _________

________ not otherwise available

Example: Dual Capacity

Domco earns $4.2 million before-tax profit mining diamonds in Hostia. Hostia imposes a “diamond tax” at ___% of the profit. Since Domco pays the diamond tax, it does not pay the general income tax of 25%. What is Domco’s creditable tax?

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(A - B - C) x D

1 - D

where A = gross receipts

B = cost and expenses

C = diamond tax

D = general income tax rate

CHECKProfit (pre-royalty)Diamond taxIncome taxRoyalty deductionProfitIncome tax rate Creditable tax

Predominant Character

• Not a ____-up levy

• Likely to reach net ____– ____________ test,– Gross _______ test, and– ___ income test

Realization Test

• Focuses on ______ of tax’s assessment

• Satisfied if assessment follows:– ___________ event– Pre-___________ event in some

cases

Gross Receipts Test

• Foreign tax base must begin with:– Actual _____ ________ or– Estimated gross receipts if result does not

______ actual gross receipts

• Gross receipts may be estimated when transactions occur between _______ persons

• _____estimating gross receipts is okay

Net Income Test

• Foreign tax must allow _________ of costs and expenses to determine tax base

• ____estimating costs and expenses okay

Soak-Up Tax

• Applies only to extent ___ is permitted

• Since U.S. law does not allow, foreign government does not ______ soak-up tax

Substitute for Income Tax

• Requirements:– Must apply __ ____ __ income tax– Cannot be a _______ tax

• Examples:– ___________ taxes on nonresidents– Special ________ taxes

Summary: Creditable Taxes

Must Be a Tax1. Compulsory2. Per tax authority

Predominant Character1. Realization test2. Gross receipts test3. Net income test4. Not a soak-up

Substitute for Income Tax1. In lieu of2. Not a soak-up

Creditable Taxes Include

• Foreign income tax paid ________, §901– Partnership’s tax _____ through to U.S. partners– Foreign branch’s tax __________ to U.S.

corporation

• Foreign tax in lieu of income tax, §___– Withholding tax on foreign investment income– Special industry tax

• ______ paid tax, §902

U.S. “green card holder” pays Belgian income tax on foreign profits

U.S. citizen has Dutch tax withheld on her Dutch dividends

U.S. individual is partner in U.K. partnership that pays U.K. income tax

U.S. corporation has Cyprian sales office that pays Cyprian income tax

U.S. corporation pays Polish income tax on profit dependent agent generates

U.S. corporation’s German subsidiary pays German income tax

U.S. family’s closely-held Mexican corporation pays Mexican income tax

Cite Code Section Identifying Each Levy as Creditable Tax

DPT Requirements

• DC owns foreign sub– Direct ownership of ___% at each link– Indirect ownership of __% in each sub– For tiers ___, foreign subs are CFCs– For tiers ___, DC is U.S. “shareholder”

• DC receives ________

DC

FC1

FC2

FC3

FC4

FC5

FC6

Example: DPT Requirements

DC

FC1

FC2

40%

10%

When FC2 remits dividends to FC1 and FC1 remits dividends to DC, can DC claim a foreign tax credit for FC2’s foreign income taxes?

DC with Foreign Branch

FBRemit $75

DC

Profit $100FITRemit

Profit $100U.S. rate

FTCU.S. tax

DC with Foreign Subsidiary

FCDividend $75

DC

Profit $100FITE&P

Dividend + gross up

$100U.S. tax rate

Tax before DPC

Deemed paid credit

U.S. tax

Calculating Deemed Paid Tax

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DPT = Dividends from foreign sub

Post-1986 E&P of foreign sub x Post-1986 foreign income tax

Example: DPT for Single TierDomco owns 40% of Forco. Forco earns $1,000 profit, pays $300 in foreign income tax, and remits $____ to Domco as dividends. What is Domco’s deemed paid tax? By how much do the dividends increase Domco’s gross income?

Domco

Forco

40%

Profit $1,000FIT 300E&P $ 700

Dividend

Example: DPT for Single TierForco is Domco’s newly-organized, 100%-owned foreign subsidiary. Forco earns $100 profit, pays $36 in foreign income tax, and remits $___ to Domco as dividends. Domco’s foreign branch makes $500 gross profit from sales and pays $50 foreign income tax.

1. What is Domco’s deemed paid tax?

3. Assuming Domco’s FTC limit is $67, what is Domco’s FTC?

2. What is Domco’s gross income?

Domco

Forco

100%

Profit $100FIT 36E&P $ 64

Branch Gross $500FIT 50

Dividend

Example: DPT for Two TiersDomco owns 100% of Forco1, and Forco1 owns 100% of Forco2. Forco1 earns $1,000 profit, pays $400 in foreign income tax, and remits $____ to Domco as dividends. Forco2 earns $100 profit, pays $25 in foreign income tax, and remits $30 to Domco as dividends. What is Domco’s deemed paid tax? By how much do the dividends increase Domco’s gross income?

Domco

Forco1

100%

Profit $1,000FIT 400

$ 600

Dividend

Forco2

100%

Profit $100FIT 25E&P $ 75

Dividend $30

Example: DPT for Two TiersDomco owns 90% of Forco1, and Forco1 owns 80% of Forco2. Forco1 earns $2,000 profit, pays $500 in foreign income tax, and remits $____ to Domco as dividends. Forco2 earns $1,000 profit, pays $400 in foreign income tax, and remits $200 to Forco1 as dividends. What is Domco’s deemed paid tax? By how much do the dividends increase Domco’s gross income?

Domco

Forco1

90%

Profit $2,000FIT 500

$1,500

Dividend

Forco2

80%

Profit $1,000FIT 400E&P $ 600

Dividend $200

Foreign Tax Credit Basics

Foreign tax credit is lesser of:Creditable tax orFTC limitation

Creditable tax is sum of:Foreign income tax (§____)Tax in lieu of FIT (§____)Deemed paid tax (§____)

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FTC Limit = FSTI x U.S. ETR

Tax Rate Basics

€

U.S. effective tax rate = U.S. tax

U.S. profit

€

Foreign effective tax rate = Foreign tax

Foreign profit

€

Worldwide effective tax rate = U.S. tax + Foreign tax

Worldwide profit

€

MTR from foreign investment = Incremental foreign tax

Incremental foreign profit

Example: Foreign Tax CreditDomco’s U.S. ETR is 34%. Domco earns $____ foreign profit and $300 U.S. profit. Its creditable taxes are $60. Compute the following for Domco:

1. Foreign ETR

2. §904 limitation

3. Foreign tax credit

4. U.S. tax liability

5. Excess credit or excess limit

6. Worldwide ETR

7. MTR on foreign profit

Example: Foreign Tax CreditDomco’s U.S. ETR is 34%. Domco earns $200 foreign profit and $300 U.S. profit. Its creditable taxes are $___. Compute the following for Domco:

1. Foreign ETR

2. §904 limitation

3. Foreign tax credit

4. U.S. tax liability

5. Excess credit or excess limit

6. Worldwide ETR

7. MTR on foreign profit

Examples: Marginal Tax Rates

What is Domco’s MTR on its foreign profit in each of the following situations?

1. U.S. ETR is 34%, and foreign ETR is 30%.

2. U.S. ETR is 34%, and foreign ETR is 36%.

3. U.S. ETR is 34%, and foreign ETR is 42%.

4. U.S. ETR is 34%, and foreign ETR is 25%.

Examples: U.S. Residual TaxAssume the U.S. effective tax rate is 35%. In the following situations, what is Domco’s U.S. residual tax rate on its foreign profits?

1. Foreign ETR is 30%.

2. Foreign ETR is 36%.

3. Foreign ETR is 42%.

4. Foreign ETR is 25%.

Business in Low-Tax Countries

• Capital ______ neutral

• Residual U.S. tax due when ______ ________

• MTR equals ____ ___ if profits remitted currently

• Creates incentive for ____-taxed _______ income

Business in High-Tax Countries

• Capital ______ neutral

• No ____ ________ tax due

• MTR equals _______ ___

• Creates incentive for ___-taxed _______ income

Excess Credit Planning

• Decrease foreign ETR– Remit foreign profits in __________ form– ______ offshore in high-tax countries– Use _______ _______ to shift income from

high-to low-tax countries

• Increase low-taxed FSTI– Export, passing title ______– Lease ______ assets and buy ____ assets– License technology for use abroad in country

with ___ royalty ___________ tax

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FTC = Lesser of: Creditable taxes or FSTI

WWTI x (WWTI x U.S. ETR)

Deferral Effect on MTR

• When DCs conduct business abroad through foreign subsidiaries, deferring dividends ______ the MTR on foreign profits.

• In low-tax countries, ____ ________ tax is deferred.

• In high-tax countries, _______ ___________ tax is deferred.

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MTR = tf + tus - tf

(1 + d)y

€

MTR = tf + tdiv (1 - tf )(1 + d)y

Example: MTR in Low-Tax Country

Domco’s wholly-owned foreign subsidiary, Forco, operates in a country with a ___% ETR. Assume the U.S. ETR is 34%, and Forco distributes all its E&P as dividends in the current year. What is Domco’s MTR on Forco’s foreign profits?

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MTR = tf + tus - tf

(1 + d)y

Assume the same facts except that Forco does not plan to distribute current profits for 4 years and the applicable discount rate is 12%. What is Domco’s MTR on Forco’s foreign profits?

Example: MTR in High-Tax Country

Domco’s wholly-owned foreign subsidiary, Forco, operates in a country with a ___% ETR and a ___% dividend withholding tax. Assume the U.S. ETR is 34%, and Forco distributes all its E&P as dividends in the current year. What is Domco’s MTR on Forco’s foreign profits?

Assume the same facts except that Forco does not plan to distribute current profits for 4 years and the applicable discount rate is 12%. What is Domco’s MTR on Forco’s foreign profits?

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MTR = tf + tdiv (1 - tf )(1 + d)y

FTC Baskets

• Cross-crediting decreases U.S. ________ ___

• Investment income is highly ______

• Congress decided to limit _______________

• Nine baskets, each containing– __________ taxes– FTC __________– _________ periods

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FTC = Lesser of: Creditable taxes or FSTI

WWTI x U.S. tax before FTC

Pre-2007 FTC Baskets

PassiveIncome

High WithholdingTax Interest

Noncontrolled §902Corporation Dividends

Financial ServicesIncome

ShippingIncome

DISCDividends

FSC ForeignTrade Income

FSCDividends

ResidualIncome

• Cross-crediting ______ baskets is permitted

• Cross-crediting _____ baskets is not

• Each basket has its own §904 _________ formula and ________ period

• No segmentation by ______

Passive Income Basket

• Portfolio dividends, some interest, non-business _____ and royalties, annuities, some net _____

• High-taxed income is “______-___”

• ___-tax basket

Residual Basket

• ____________, marketing, and service income

• _______ profit (other than FSC or DISC)

• Business rent and _______ income

• “______ ___” passive income

Example: FTC BasketsDomco earns income and pays taxes as follows:

Taxable Income

U.S. Tax Before FTC Foreign Tax

Foreign Operations $ 400,000 $ 136,000 $ 180,000

U.S. Operations 500,000 170,000 0

Foreign Portfolio Dividends 100,000 34,000 10,000

Totals $1,000,000 $ 340,000 $ 190,000

What is Domco’s foreign tax credit if it ignores separate baskets?

Example: FTC BasketsDomco earns income and pays taxes as follows:

Taxable Income

U.S. Tax Before FTC Foreign Tax

Foreign Operations $ 400,000 $ 136,000 $ 180,000

U.S. Operations 500,000 170,000 0

Foreign Portfolio Dividends 100,000 34,000 10,000

Totals $1,000,000 $ 340,000 $ 190,000

What is Domco’s foreign tax credit if it considers separate baskets?

CFC Look-Through

• CFCs are foreign corporations that U.S. shareholders _______.

• Look through rules allocate foreign _______ income U.S. companies receive from ____ among baskets.

Example: Look-ThroughDomco receives $______ dividends from its wholly-owned foreign subsidiary, Forco. Forco pays ___% of its dividends from E&P attributable to its business operations and the rest from E&P attributable to its passive investment activities. How does Domco treat these dividends for FTC purposes?

Recapture of Foreign Loss

• U.S. companies pay U.S. tax on _________ income.

• Thus, overall losses from foreign activities are deductible against ____ source income.

• However, this reduces ____ tax on ____ source income.

• So, §904(f) contains a _________ rule.

Recapture of Foreign Loss

• If overall foreign loss occurs,– ______ against U.S. income but– Recapture in later year

• Involves treating ___ as ____

• Affects ___ limitation

• Recapture lesser of:– _______ foreign ____ account or– ___% of current year’s ____

Example: OFL RecaptureDomco earns income and pays taxes as follows:

Irish Income

Irish Taxes

U.S. Income

U.S. Tax Before FTC

2003 $-24,000 0 $ 74,000 $ 7,500

2004 -10,000 0 80,000 12,500

2005 30,000 3,750 70,000 22,500

2006 40,000 5,000 60,000 22,250

What is Domco’s foreign tax credit in 2005 and 2006?

Tax Sparing

• Host countries may allow “tax ________”

• Holiday creates incentive to invest when ____ country has:– ___________ system or– Tax _______

• Sparing allows residents to ______ foreign taxes the host country ______

Tax Sparing

• “Tax sparing credits” are the same as foreign tax credits except investors ___ __ foreign income tax

• __ U.S. treaties allow tax sparing

A company invests abroad and earns $100. Assuming home and host country tax rates of 50% and ___%, respectively, determine the total tax liability with: • No tax holiday • Tax holiday without tax sparing • Tax holiday with tax sparing

Tax Sparing Example

No Tax Holiday

Tax Holiday with Sparing

Tax Holiday without Sparing

Host Country

Home Country

Tax liability

Initial taxTax credit

Tax liability