2013-Issue 7—With the 2012 U.S. election in the rear-view mirror and the global economy sputtering along with modest projections for growth, now is a good time to dust off your foreign tax credit (FTC) calculations and get "back to basics" for 2013 and beyond.
New "instantly global" companies should understand the basic FTC calculation, while more developed companies of all sizes should refresh their FTC knowledge and calculations. This may be a good time for chief tax officers to remind and educate their CFOs about the FTC and the interplay with U.S. and foreign losses and the rules governing their recapture, particularly in light of various proposals for international tax reform.
As a refresher, under fairly complex U.S. income tax rules, a foreign tax credit is allowed only against U.S. federal income tax when a taxpayer has both positive foreign source income and positive worldwide income. During the Great Recession and subsequent anemic recovery, it was common for companies to have a foreign loss or a domestic loss or both, often preventing the use of the foreign tax credit.
But with the global economy gaining modest traction and somewhat optimistic projections for 2013 and beyond, tax credits, including the FTC, are potentially freeing up for current or future use. To get the most out of your FTC, tax and finance teams need to know how the FTC mechanism works, whether the company's taxes are eligible for creditability, the amount of the company's allowable FTC and how the company will be able to maximize the benefit from claiming the FTC. It will also be important to understand how the company will account for the FTC in its financial statements.
1. Foreign Tax Credit Basics
Under U.S. tax law, all income from foreign sources is generally divided into two "baskets" for foreign tax credit purposes: general limitation and passive limitation. The passive basket contains passively earned income, which generally includes interest, dividends, royalties and other similar types of unearned income. The general basket consists of everything else. Foreign taxes paid are allocated between the two baskets according to the classification of the income to which they relate.
The foreign tax credit for each basket is limited every year to the lesser of two amounts: 1) the proportion of U.S. income tax on foreign source income (calculated as the product of U.S. income tax on worldwide income multiplied by the ratio of foreign source income to worldwide income), or 2) foreign taxes paid or accrued. If there is no foreign source income, the equation will result in no allowable foreign tax credit.
The other necessary prerequisite is U.S. income tax liability. If a company has no tax liability, there is nothing to use the foreign tax credits against, and the credits will be carried over to another year. Any net operating loss (NOL) carryovers should be applied to reduce taxable income before calculating the tax liability for foreign tax credit purposes. Companies in an NOL position will be unable to take a foreign tax credit until that position reverses. Often companies in an NOL position elect to deduct foreign taxes when they are unable to use the FTC and later amend their tax returns to elect to use the FTC.
A foreign tax credit may be taken only if a company has directly or, in limited circumstances, indirectly paid foreign taxes. You may not be able to credit the foreign taxes against your U.S. income tax liability in the year the foreign taxes were paid or accrued because of the limitations discussed above. Foreign taxes that have been paid or accrued, but not credited, may be carried back one tax year or forward 10 tax years, to a tax year in which they can be used. After 10 years, the foreign taxes expire and may no longer be used as a credit. Consequently, accurate recordkeeping of when foreign taxes were paid and how much was paid is very important. "Forgotten" or undocumented foreign taxes harm the taxpayer because they cannot be used to reduce U.S. income tax liability and unnecessarily increase global tax expense.
Foreign income taxes paid by foreign subsidiaries, otherwise known as taxes deemed paid, pose an even greater recordkeeping burden. Generally, taxpayers are entitled to take a credit for taxes they paid directly. However, when a U.S. C corporation owns at least 10 percent of a foreign corporation, it has the potential to take a tax credit for foreign taxes paid by that foreign corporation. The taxes deemed paid by the domestic corporation in a given year are equal to the remaining foreign taxes paid after 1986 ("foreign tax pool") by the foreign corporation multiplied by the proportion of the amount of actual or deemed distributions made by the foreign corporation to the
U.S. shareholder during the taxable year divided by the foreign corporation's remaining earnings and profits earned after 1986 ("E&P pool"). For older years, an annual layering system governs FTC use. In either case, none of the taxes in the foreign tax pool or layer are deemed to have been paid by the domestic corporation until a distribution has been made. Distributions include actual dividends and deemed dividends under anti-deferral rules (i.e., Subpart F). Once the taxes are deemed paid, the 10-year expiration period begins.
It is conceivable that taxes paid nearly 30 years ago may have the potential to generate an indirect foreign tax credit. Trying to go back several years to determine the generation of earnings and profits in a given year, the amount of foreign taxes paid, where the supporting documents are located and whether prior distributions have been made can be very difficult or even impossible. It is a best practice to track these amounts on an annual basis. Incomplete data may result in overstated E&P pools and understated foreign tax credits — or vice versa, understated E&P pools and overstated foreign tax credits. While one represents a lost opportunity, the other may result in IRS penalties; both result in an economic cost.
Once taxpayers calculate taxes paid directly and indirectly for the current year and the amounts carried forward, the company determines how much of the creditable taxes in each basket may be used as a foreign tax credit in the current tax year.
2. The Effects of Foreign and Domestic Losses on the Foreign Tax Credit
The presence of an overall foreign loss (OFL) or an overall domestic loss (ODL) may reduce foreign or domestic source income and affect the allowable amount of foreign tax credit in a given year. OFL is a technical term that describes the amount by which foreign source gross income for a taxable year is less than the properly allocated deductions. Many OFLs are caused by the apportionment of interest expense to foreign assets, particularly foreign stock. In our experience, companies are often surprised to learn that while they did not have foreign source income in the past, they accumulated OFLs in an OFL account. This may limit the company's ability to utilize the creditable taxes associated with foreign subsidiary dividends.
The OFL is the net amount of the gains and losses of the passive income basket and the general income basket. If a gain in one basket is completely offset by a loss in the other basket, the U.S. tax rules require that taxpayers track the offset gain as a separate limitation loss (SLL). The SLL will be reversed in future years when there is enough income generated in the loss basket to equal the amount of the offset gain.
Likewise, ODL is a technical tax term that describes the amount of the domestic loss for a taxable year that offsets foreign source income. The domestic loss is the amount by which the sum of the properly allocated deductions exceeds the U.S. source gross income for the taxable year. In years where there are both net foreign losses and domestic losses, an OFL is generated to the extent of the foreign loss, but no ODL is generated. ODLs are relatively new and need to be traced from January 1, 2007.
The rules in this area require tracking of OFLs and ODLs in separate OFL and ODL accounts that should be monitored over time. In subsequent years, complex ordering rules require that these accounts must be resourced and potentially recaptured if these losses offset other income. In the case of an OFL, any net positive foreign source income must be recharacterized as U.S. source income equal to the lesser of the aggregate amount of "maximum potential recapture" in the OFL account or 50 percent of the taxpayer's total foreign source taxable income, until the OFL account is fully recaptured. The opposite is true for an ODL — any net positive U.S. source income must be recharacterized as foreign source income, until the ODL account is fully recaptured. The rules for recapture are complicated and usually result in intricate calculations, particularly when a company has accumulated OFL, ODL and SLL accounts.
Alvarez & Marsal Taxand Says:
While it can be easy to put off foreign tax credit tracking until it becomes relevant, it often leads to time-consuming exercises to determine the true foreign tax credit position. Having a command of the underlying data is essential to correctly calculating your foreign tax credit. Tracking relevant foreign tax credit attributes, like foreign taxes paid, OFLs, ODLs and foreign tax credit carryforwards, saves time and money in the long run. This information also proves invaluable when determining your company's strategy for foreign investments and repatriations.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.