The article was first published in Global Tax Weekly, issue 159. Below is the full text of the third article in the series on US taxes for US persons living outside the US.
US Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US – Foreign Tax Credits I
by Stephen Flott, and Brittany Oravec, Flott & Co. PC
This is the third article in a series of articles on key US tax compliance and planning issues that should be considered by US executives, entrepreneurs and investors living outside the United States. This third article provides an overview of Foreign Tax Credits for US Persons. The next article will address foreign tax credits for companies.
The United States system of taxing US Persons1 and US companies on worldwide income creates the potential for double taxation of foreign source income because the US taxes US persons and companies on their worldwide income. Thus, income that is subject to US tax is very likely to have been taxed in the country in which it was earned. To avoid what would be a quite intolerable burden on its taxpayers, the US allows the use of foreign tax paid as a dollar for dollar credit against US tax due on the same income. Essentially, foreign tax credits offset US tax, thus eliminating double taxation of the same income.2
The following four tests must be met to claim credit for a foreign tax:
- The tax must be a legal and actual foreign tax liability;
- The tax must be imposed on the taxpayer;
- The taxpayer must have paid or accrued the tax; and
- The tax must be an income tax (or a tax in lieu of an income tax).
To qualify as an income tax, the foreign tax must:
(i) Be a tax imposed on income from an event or transaction that would trigger a realization of income under US tax principles;
(ii) Be imposed on gross receipts; and
(iii) Permit the recovery of significant costs and expenses attributable to the US taxpayer’s gross income.
Withholding taxes of a foreign country generally would not qualify as an income tax because deductions are not allowed in computing the tax base. Foreign withholding taxes, however, will usually qualify as a creditable foreign income tax because the withholding taxes are routinely imposed in lieu of the general income tax.
The foreign tax credit allows a US taxpayer to subtract income taxes paid to other countries from the tentative tax owed to the US government. Foreign taxes other than income taxes (such as property taxes, excise taxes, payroll taxes, or value-added taxes) can be deducted from foreign source taxable income, but cannot be credited against US tax. All foreign income taxes can be credited against US federal income tax, including taxes levied by governments below the national level.
US taxpayers have the option of claiming the foreign income taxes paid as either a tax credit or a deduction against income. Usually the credit is more advantageous than the deduction because a tax credit provides a dollar-for-dollar reduction in current income tax liability; whereas, a deduction lowers the US taxpayer’s income that is taxable, and the benefit is measured by the taxpayer’s marginal income tax bracket.
Generally, US Persons who reside in countries with tax rates higher than the US will minimize their US tax exposure by only using the foreign tax credit; and US Persons who reside in countries with tax rates lower than the US will minimize their US tax exposure by using the foreign earned income exclusion. Other factors will impact these general statements, such as marginal tax brackets, exclusions, and deductions from income taxes.
The United States limits the foreign income taxes that US taxpayers can credit against their US income tax liability. The limitation equals the pre-credit US federal tax that is attributable to foreign source income. The purpose of the limitation is to restrict foreign tax credits to mitigating double taxation on foreign source income. The limitation prevents US taxpayers operating in high-tax jurisdictions from using foreign tax credits to reduce tax imposed on US source income.
When the foreign tax credit was first enacted, it was subject only to an overall limitation. There was no separation between earned income and passive income which allowed US taxpayers easy opportunities to offset excess foreign tax credits in high-tax jurisdictions with the US tax that would otherwise be imposed on foreign income generated in low-tax jurisdictions. To combat the perceived abuse of the overall credit limit, the Tax Reform Act of 1986 (“1986 Act”) divided foreign source income into eight separate categories or baskets within which a separate foreign tax credit limitation was applied. Excess foreign tax credits in one category cannot be used to offset US tax on foreign source income in another category.
In 2007, the eight separate limitation baskets were reduced to two primary baskets. Under the current regime, there are separate tax credit limitations for passive category income and general category income.
General category income includes earned income of US Persons and most foreign source active business of domestic corporations and their foreign subsidiaries. Passive category income includes:
(i) Dividends, interest, royalties, and annuities;
(ii) Net gains from the disposition of property that produces dividend, interest, rent, and royalty income;
(iii) Net gains from commodity and foreign currency transactions; and
(iv) Income of a passive foreign investment company that has made a qualified electing fund election.
If there are foreign income taxes paid that, due to the limitation, cannot be used, US taxpayers can carry the “excess” foreign tax credits back one year and forward ten years. The carryover of foreign tax credits must take place within the limitations of the separate categories or “baskets” of foreign source income. Excess credits that are carried back or forward to another year can only be claimed as a credit in the carry back or forward year. They cannot be used as a deduction.
US Persons will almost always compute their taxable income and their foreign tax credit on the cash basis. Under the cash method, the foreign tax credit is credited in the year paid. Recognizing that there could be a matching issue with foreign taxes paid with foreign source income, cash-basis taxpayers are allowed to elect to compute the foreign tax credit on the accrual basis.
For US Persons, additional complexities arise in computing the foreign tax credit when dealing with foreign source income that is taxed at preferential rates in the US. If there were no adjustments made to the foreign tax credit computation, the tax preferred tax rates of capital gains could distort the accuracy of the foreign tax credit limitation as an estimation of US tax attributable to foreign source income. This distortion occurs because the US tax rate on net long-term capital gains is lower than the tax rate applied to ordinary income for individuals. Therefore, when there is a capital gain differential, an adjustment is made to the foreign tax credit limitation so that the pre-credit US tax on foreign source taxable income is based on the average rate of US tax on ordinary income and on net long-term capital gain. A US Person also adjusts or reduces the foreign tax credit limitation fraction by a portion of any foreign source capital gain income due to the tax rate differential. The reason for the adjustments is to ensure the proper foreign tax credit is computed whether there are US source or foreign source capital gains that could distort the foreign tax credit computation due to the tax rate differential between ordinary income and capital gains. Failure to make these adjustments reduces the value of foreign tax credits.
US taxpayers can realize a double tax benefit when allocated foreign deductions exceed foreign source income for the taxable year for aggregate foreign source income. This is known as “overall foreign loss” (“OFL”). The OFL provides a US taxpayer with a loss offsetting US taxable income during the current taxable year. Future collection of US taxes on foreign taxable income will not compensate the current year reduction in US taxable income if the foreign tax credit in future years offsets the US tax on foreign source income. The OFL allows the use of foreign losses to reduce US source income and the potential for foreign tax credits in profitable years to avoid US income tax on foreign source income.
To counteract this potential double benefit, a US taxpayer who has an OFL in each succeeding year will recapture as US source income the lesser of:
(i) 50 percent (or a larger percentage elected by the US taxpayer) of foreign source taxable income for that succeeding year; or
(ii) The amount of the OFL that has not yet been recaptured.
The mechanics of the recapture rule are to allocate foreign source income to US source income so that foreign tax credits do not shelter tax on foreign source income where there was a previous OFL.
Similar to the OFL, adjustments to the foreign tax credit computation are required when there is a foreign source loss arising only in one of the separate income categories or baskets. This is known as the “separate loss limitation” (“SLL”). When a loss occurs in the passive category income or general category income, the US taxpayer must allocate the loss to the other category of foreign source income before the loss can offset US source income. In subsequent tax years, any income earned in the category of income that incurred the SLL is characterized as income in the other category to the extent the SLL had been previously allocated to that other category of foreign source income. For example, in year one there is a USD5 loss in the passive category limitation and a USD10 gain in the general category limitation. Under the SLL rules, the USD5 passive category limitation loss is allocated to the general category limitation so that there is now a USD5 gain in the general category limitation. In year two there is a USD10 gain in the passive category limitation; USD5 of the passive category gain in year two will be allocated to the general category limitation.
A similar issue to the OFL occurs in reverse where there is an “overall domestic loss” (“ODL”) in a taxable year. This would occur when overall US source deductions exceed overall US source income. Since the ODL will reduce the US taxpayer’s foreign source income, the ODL could deny the US taxpayer foreign tax credits. A US taxpayer in each year following an ODL can recapture the ODL amount by treating US source income as foreign source income in an amount equal to the lesser of 50 percent of the US taxpayer’s US source taxable income in the recapture year or the amount of the ODL that has not been recaptured.
As anyone who has read to this point will realize, foreign tax credits play an important role in eliminating double taxation of foreign source income. However, readers will also realize that the rules governing the application of foreign tax credits are rather complex. This is particularly the case for individual US taxpayers living overseas. The next article will address the foreign tax credit complexities for US companies, which are usually better equipped to handle them.
1 The term “US Person” as used in these articles includes only US citizens. It should be noted that legal permanent residents (LPRs) and non-citizens who spend more than 182 days in the US during a tax year are US Persons for tax purposes. LPRs cease to be US Persons when they abandon their status. Non-citizens cease to be US Persons as soon as they spend fewer than 183 days in the US during a tax year. The calculation of days present in the US for purposes of determining the substantial presence test includes one sixth of the days spent in the two years prior to the current tax year, one third of the days spent in the year prior to the current tax year, and all of the days spent in the US during the current tax year. Effectively, non-citizens should not spend more than 122 days a year in the US during any consecutive three-year period to avoid being a US Person for US tax purposes.
2 It should be pointed out that to the extent that the foreign tax paid on foreign source income is less that the US tax applicable to the same income, the US Person will pay the difference. For example, if the equivalent of USD10,000 in interest income is taxed at 10 percent in a foreign country and the US Person is subject to tax at a marginal rate of 15 percent on the same income, the US Person will pay the 5 percent differential to the US Treasury. In the opposite circumstance, the US Person will have a tax credit carry forward of 5 percent.