{"id":1759,"date":"2016-02-03T09:46:21","date_gmt":"2016-02-03T14:46:21","guid":{"rendered":"http:\/\/www.flottco.com\/doingbusinessacrossborders\/?p=1759"},"modified":"2016-02-17T11:58:52","modified_gmt":"2016-02-17T16:58:52","slug":"us-tax-compliance-and-planning-for-us-executives-entrepreneurs-and-investors-living-outside-the-us-foreign-tax-credits-ii","status":"publish","type":"post","link":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/us-tax-compliance-and-planning-for-us-executives-entrepreneurs-and-investors-living-outside-the-us-foreign-tax-credits-ii\/","title":{"rendered":"US Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US \u2013 Foreign Tax Credits II"},"content":{"rendered":"

The article was first published in\u00a0Global Tax Weekly<\/a>, issue 160. Below is the full text of the fourth\u00a0article in the series on US taxes for US persons living outside the US.<\/p>\n

US Tax Compliance And Planning For\u00a0US Executives, Entrepreneurs And\u00a0Investors Living Outside The US \u2013\u00a0Foreign Tax Credits II\u00a0<\/strong><\/p>\n

by Stephen Flott, Christopher Krug,\u00a0and Brittany Oravec, Flott & Co. PC<\/p>\n

This is the fourth article in a series of articles on key US\u00a0tax compliance and planning issues that should be considered\u00a0by US executives, entrepreneurs and investors\u00a0living outside the United States. This article provides\u00a0an overview of Foreign Tax Credits for US companies.<\/em><\/p>\n

\"ForeignForeign tax credit reporting is particularly important\u00a0for US companies. US companies with operations\u00a0abroad routinely create foreign entities\u00a0in those countries to carry out the operations. For\u00a0US tax purposes, the foreign entity will be classified\u00a0as a corporation, partnership or disregarded\u00a0entity based on default classification rules. With\u00a0the exception of certain per se <\/em>corporations, the US\u00a0taxpayer can elect the US tax classification of the\u00a0foreign entity. The US tax classification of a foreign\u00a0entity is important for tax credit planning as foreign\u00a0tax credits will flow through to the US owners\u00a0of foreign partnerships and disregarded entities,\u00a0whereas, generally, foreign tax credits do not flow\u00a0through to the US owners of foreign corporations.<\/p>\n

A US company operating in a foreign country\u00a0through an entity classified as a partnership will be\u00a0allocated its pro rata <\/em>share of foreign tax credits to\u00a0offset US taxation on the US company’s pro rata\u00a0<\/em>share of foreign source income. In determining the\u00a0separate basket limitations, a partner allocates its\u00a0distributive share of partnership income between\u00a0general category income and passive category income\u00a0based on the character of the income at the\u00a0partnership level.<\/p>\n

Foreign tax credit planning for US companies operating\u00a0in foreign countries through foreign subsidiary\u00a0corporations is more complex than the rules\u00a0for a pass-through entity. US corporations normally\u00a0cannot claim a dividend received deduction on\u00a0a dividend received from a foreign corporation. A\u00a0US corporation therefore generally must recognize\u00a0the entire amount of a dividend from a foreign subsidiary\u00a0as US taxable income. The reason the rule\u00a0diverges from a dividend between a US parent and\u00a0US subsidiary corporation is that the dividend distribution\u00a0from the foreign corporation is the first\u00a0chance the US has to tax the profits of the foreign\u00a0subsidiary, whereas the US subsidiary is subject to\u00a0US taxation on its worldwide income.\u00a05\u00a0<\/strong>Foreign countries usually impose a withholding\u00a0tax on dividends of a foreign corporation paid to\u00a0a US shareholder. If the US has a tax treaty with\u00a0this country, the withholding tax in that country is\u00a0usually reduced to 15 percent and to 10 percent for\u00a0controlling shareholders. Under the Internal Revenue\u00a0Code, a US taxpayer can claim a foreign tax\u00a0credit for any foreign withholding tax incurred on\u00a0a dividend from a foreign corporation.<\/p>\n

A US corporation with foreign subsidiaries is eligible\u00a0to claim deemed paid foreign tax credits if it\u00a0owns 10 percent or more of the voting stock of a\u00a0foreign corporation and receives a dividend distribution\u00a0from that foreign corporation. The deemed\u00a0paid foreign tax credit is allowed to protect US\u00a0corporations from double taxation and to closer\u00a0equate the tax treatment of US corporations with\u00a0foreign subsidiaries with those operating through\u00a0foreign partnerships or disregarded entities. This allows\u00a0US corporations to choose to operate through\u00a0a foreign corporation or foreign partnership\/foreign\u00a0disregarded entity on a legal basis as opposed\u00a0to US tax consequences.<\/p>\n

Since a US corporation generally does not recognize\u00a0income from a foreign corporation until there\u00a0is a distribution, the deemed paid foreign tax credit\u00a0could allow a US corporation to recognize a foreign\u00a0tax credit prior to the related income being taken\u00a0into account. To prevent this tax credit and income\u00a0matching issue, there are now provisions requiring\u00a0the related foreign income recognition as a prerequisite\u00a0to receiving the deemed foreign tax credit.\u00a0Another issue that arises with the deemed foreign\u00a0tax credit is in determining whether a US corporation\u00a0is taxable on a distribution from a foreign\u00a0corporation as a dividend, the foreign corporation’s\u00a0earnings and profits is reduced by foreign\u00a0taxes paid. As a brief background, US taxpayers are\u00a0subject to tax on dividends from a foreign corporation\u00a0to the extent of the distributing corporation’s\u00a0earnings and profits. If a distribution exceeds the\u00a0distributing corporation’s earnings and profits, the\u00a0distribution is a tax-free return of capital to the extent\u00a0of the US taxpayer’s basis in the stock of the\u00a0foreign corporation. If the distribution exceeds the\u00a0US taxpayers’ basis in the stock of the foreign corporation,\u00a0the distribution is taxed as a long-term\u00a0capital gain. The issue that arises with the deemed\u00a0foreign tax credit is that the US corporation would\u00a0receive the foreign tax credit while the earnings and\u00a0profits, which determine whether the distribution\u00a0from the foreign corporation is taxable as a dividend\u00a0to the US taxpayer, is reduced by the same\u00a0foreign taxes paid by the foreign corporation. To\u00a0prevent this double tax benefit of both a deemed\u00a0foreign tax credit and deduction from earnings and\u00a0profits in the same amount, the US corporation\u00a0must gross up its dividend by the amount of the\u00a0deemed paid tax credit.<\/p>\n

Another complication of the deemed paid credit\u00a0and the matching of income and taxes requirement\u00a0is allocating deemed paid taxes to dividend\u00a0distributions. If the foreign corporation simply\u00a0paid all of its earnings out every year, the allocation\u00a0of deemed paid credits would not be an issue.\u00a06\u00a0<\/strong>In contrast, where a foreign corporation accumulates\u00a0earnings over a number of years, the allocation\u00a0of deemed paid taxes is more important. The allocation\u00a0of deemed paid credits is more significant\u00a0where the tax rate in the foreign country increases\u00a0or decreases during the period the foreign corporation\u00a0accumulated earnings. Under the old rule, a\u00a0US corporation allocated deemed foreign tax credits\u00a0on a last in, first out basis. Congress felt the last\u00a0in, first out method allowed bunching of income of\u00a0the foreign corporation income and in turn allowed\u00a0US corporations an opportunity to maximize their\u00a0deemed paid credits.<\/p>\n

For post-1986 foreign income taxes, the pooling\u00a0method is required to allocate deemed paid foreign\u00a0tax credits. Under the pooling method, post-1986\u00a0undistributed earnings of a foreign corporation are\u00a0computed at the end of the taxable year in which\u00a0the foreign corporation makes a distribution to a US\u00a0corporation. The post-1986 undistributed earnings\u00a0equal the aggregate amount of the foreign corporation’s\u00a0undistributed earnings and profits for taxable\u00a0years commencing after December 31, 1986.\u00a0This amount is reduced by actual dividend distributions\u00a0from prior taxable years and for any Subpart\u00a0F Income1 previously included in the US corporation’s\u00a0income. The foreign corporation’s post-1986\u00a0income taxes for the deemed paid taxes equal the\u00a0aggregate amount of the foreign corporation’s foreign\u00a0income taxes for taxable years starting after December\u00a031, 1986. This amount is reduced by the\u00a0amount of foreign income taxes related to prior year\u00a0dividend distributions and Subpart F inclusion.\u00a0Under the pooling method, the foreign corporation’s\u00a0post-1986 foreign income taxes are multiplied\u00a0by the ratio of the current year dividend to the\u00a0foreign corporation’s post-1986 undistributed earnings.\u00a0As compared to the last in, first out method,\u00a0the pooling method evenly allocates the post-1986\u00a0foreign corporation’s income taxes in proportion to\u00a0the post-1986 undistributed earnings.<\/p>\n

Since the foreign tax credit is the primary vehicle\u00a0for US Persons and US companies to avoid double\u00a0taxation of foreign source income, proper planning\u00a0for the foreign tax credit and dividend repatriation\u00a0is critical. It will be important for the US taxpayer\u00a0to look for opportunities to reduce and eliminate\u00a0excess foreign tax credits carryovers. For the\u00a0US corporation, it will be important to strategize\u00a0for tax-efficient dividend repatriation from foreign\u00a0corporation subsidiaries.<\/p>\n

A US taxpayer can reduce foreign tax credit carryovers\u00a0by increasing the proportion of worldwide\u00a0income allocated to either of the separate categories\u00a0of income limitation. Since the foreign tax credit is\u00a0computed in part based on the percentage of separate\u00a0category compared to worldwide income, increasing\u00a0the income in the foreign source separate\u00a0category income will increase the foreign tax credits\u00a0allowed for that category. For a US company, one\u00a0opportunity to increase the foreign source income\u00a0to a separate category can be determining where\u00a0title to goods pass for international sales. Arranging\u00a0for passage of title in the foreign country will\u00a0increase the foreign source income and increase\u00a07\u00a0<\/strong>the allowable foreign tax credits. Likewise, another\u00a0planning opportunity is to look at opportunities\u00a0to source deductions to the US as opposed to the\u00a0foreign country, which in turn reduces overall US\u00a0source income and increases overall foreign source\u00a0income leading to a larger foreign tax credit. It is\u00a0important that the planning for the sourcing of income\u00a0and deductions is reviewed both from a US\u00a0tax perspective and for the tax imposed in the foreign\u00a0country. For example, the US taxpayer would\u00a0not want the net effect being the income taxes in\u00a0the foreign country increasing by more than the reduction\u00a0in income taxes in the US.<\/p>\n

Cross-crediting is still an effective means to reduce\u00a0excess foreign tax credits even with the\u00a0separate baskets of passive and general category\u00a0limitations. Cross-crediting is the process of averaging\u00a0foreign income taxed at higher rates than in\u00a0the US with foreign income taxed at lower rates\u00a0than in the US. This strategy was more effective\u00a0prior to the separate category limitations; however,\u00a0it still remains a prevalent planning opportunity\u00a0with the current passive and general category\u00a0limitations. A US taxpayer usually receives\u00a0no advantage of income being taxed at lower rates\u00a0than the US because the difference between the\u00a0foreign tax rate and the US tax rate will be collected\u00a0in the US. Therefore, the opportunity to\u00a0cross-credit between highly taxed foreign source\u00a0income and lightly taxed foreign source income\u00a0provides an opportunity to increase the foreign\u00a0tax credits within a limitation category, reducing\u00a0foreign tax credit carryforwards, and reducing the\u00a0US income tax liability.<\/p>\n

Similarly for dividend repatriation, it is important\u00a0to look at tax-efficient ways to repatriate dividends\u00a0from foreign corporations. Again, cross-crediting\u00a0provides an opportunity where foreign tax credits\u00a0from heavily taxed foreign jurisdictions can be\u00a0used to shelter residual US tax due on dividends\u00a0from lightly taxed jurisdictions. Another strategy is\u00a0claiming reduced withholding tax rates through a\u00a0foreign country with a favorable income tax treaty\u00a0with the US. Alternatives to dividends should\u00a0also be considered to repatriate earnings to the US,\u00a0for example, through interest, rent, management\u00a0fees, etc.<\/em>; there are many opportunities to repatriate\u00a0funds other than through dividend payments.<\/p>\n

The foreign tax credit is extremely important for\u00a0US taxpayers in avoiding double taxation of foreign\u00a0source income and controlling global effective\u00a0tax rate management. While the concept is\u00a0simple, there are a number of rules and exceptions\u00a0that make the computation of the foreign tax credit\u00a0complex. Proper planning for the foreign tax credit\u00a0is important for US taxpayers with foreign source\u00a0income in order to avoid double taxation and efficiently\u00a0manage their worldwide tax liability.<\/p>\n

ENDNOTES\u00a0<\/strong><\/p>\n

1 The term “Subpart F Income” refers to a specific type\u00a0of foreign source income that is currently taxable in\u00a0the US. The term will be addressed in future articles.<\/p>\n","protected":false},"excerpt":{"rendered":"

The article was first published in\u00a0Global Tax Weekly, issue 160. Below is the full text of the fourth\u00a0article in the series on US taxes for US persons living outside the US. US Tax Compliance And Planning For\u00a0US Executives, Entrepreneurs And\u00a0Investors Living Outside The US \u2013\u00a0Foreign Tax Credits II\u00a0 by Stephen Flott, Christopher Krug,\u00a0and Brittany Oravec,…<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[29,17],"tags":[],"class_list":["post-1759","post","type-post","status-publish","format-standard","hentry","category-foreign-tax-credits","category-us-taxation"],"_links":{"self":[{"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/posts\/1759","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/users\/5"}],"replies":[{"embeddable":true,"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/comments?post=1759"}],"version-history":[{"count":5,"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/posts\/1759\/revisions"}],"predecessor-version":[{"id":1775,"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/posts\/1759\/revisions\/1775"}],"wp:attachment":[{"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/media?parent=1759"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/categories?post=1759"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.flottco.com\/doingbusinessacrossborders\/wp-json\/wp\/v2\/tags?post=1759"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}