2014-Issue 29—Foreign tax credits (FTCs) aim to alleviate double taxation by providing a dollar-for-dollar reduction of U.S. tax liability. U.S. multinationals rely on FTCs to reduce cash tax, improve their effective tax rate and optimize earnings per share. They can be highly valuable tax attributes.
Many readers are likely familiar with the basic requirements for claiming FTCs. Generally, credits are available for foreign taxes directly paid (or accrued) by a U.S. entity, as well as taxes withheld on certain payments made to the U.S. company (i.e., interest, dividends, royalties, etc.). FTCs can also be considered deemed paid when the foreign taxes are embedded in the earnings of foreign operations and such earnings are repatriated or “deemed” repatriated to the U.S.
U.S. multinationals are required to clear many hurdles in order to benefit from FTCs. Only certain foreign taxes are creditable. Also, FTCs are subject to a limitation based on net foreign-source income and U.S. tax liability. Finally, FTCs must be properly substantiated.
Is your company doing everything necessary to substantiate FTCs and maintain IRS audit-readiness?
1. Substantiation Requirements
The IRS requires that all receipts of foreign taxes be provided upon request. However, many companies lack the operational functions or tools to manage this requirement. The result is poor or nonexistent record-keeping, which can create a significant hidden tax liability (and risk of delinquent taxes) when the IRS audits FTCs. Below we will discuss how to address this risk, but first let’s take a closer look at the IRS requirements for substantiation.
The United States Treasury Regulations provide very strict rules on the requirement to maintain foreign tax receipts or returns. The regulations require that the taxpayer provide “upon request” the receipt or the tax return that verifies payment of tax if a credit is sought. (See Treas. Reg. 1.905-2(a)(2).) Tax returns or receipts must either be the original, a duplicate original or a duly certified or authenticated copy. Furthermore, if the receipts and returns are not in English, the taxpayer must furnish a certified translation of the documents.
The Secretary has wide discretion in accepting or rejecting secondary forms of evidence, as it must be established that primary forms of evidence are “impossible to furnish” before secondary forms can be considered. (See Treas. Reg. 1.905-2(b).) The Regulations define three different categories of secondary evidence that may stand in — at the auditor’s discretion — for receipts and tax returns. Each category requires a detailed list of items. For example, if a receipt for a tax payment is not available, the auditor may choose to accept a photocopy of the check showing amount and date of tax payment, along with certification identifying it with the tax claimed. (See Treas. Reg. 1.905-2(b)(1).) If a company does not have primary evidence in the form of a receipt, it is up to the IRS agent to decide whether to accept secondary evidence or deny the evidence together with the credit.
These regulations are burdensome for the taxpayer, especially when you are under IRS audit for taxes paid in past years. In such a situation, it can be difficult or impossible to track down receipts not already on file.
Ask yourself: Will overseas salespeople, finance teams or third-party customers be motivated to assist in an eleventh-hour scramble for documentation?
The best solution is to be prepared with proper substantiation procedures.
2. Are You Prepared?
Receipt compliance gets very complicated very fast. In a best-case scenario, a corporation is paying foreign income taxes directly to a foreign taxing authority, and there is a system in place to collect and retain all returns and receipts of payment. At the outset of an IRS audit, the receipts are either immediately available in a local file-drive or readily available at a foreign subsidiary.
Now consider a more complicated, but all too common, situation. A company has foreign taxes withheld on an intercompany or third-party transaction, and no receipts are provided to the U.S. division for these tax payments. What happens when the credits come up for audit by the IRS? The Service’s procedures typically allow taxpayers only a short amount of time to substantiate the FTCs claimed. Under these strict time constraints it becomes difficult, if not impossible, to collect, translate and organize your receipts.
Occasionally third-party withholding agents are customers with no real incentive to cooperate in digging up numerous receipts from transactions that occurred in years past. Pushing hard for such favors on a tight schedule can risk these valued customer relationships. If the effort to collect receipts falls short, the IRS can move directly to delinquency for back taxes.
Another layer of complexity is added when multiple jurisdictions are in the mix. Requesting receipts from just a single country can differ significantly in complexity from requesting receipts from customers in multiple countries representing several languages and levels of economic development. Taxpayers have encountered challenges ranging from receiving handwritten receipts to claiming withholding taxes that were never remitted to the taxing authority. These challenges are preventable with the correct substantiation system in place.
3. The Solution — Build a System for Record-Keeping
The solution is to build a process that aligns tax, finance and business goals to create a system of sustainable record-keeping. An ideal system will leverage your current accounting system.
At a minimum, building a substantiation system requires the following five steps:
(1) Review Form 1118 and supporting workpapers to analyze your current FTC position;
(2) Review supporting documentation currently on hand;
(3) Review and program your accounting systems to track foreign taxes accrued and paid;
(4) Develop a methodology and implement required new protocols and safety measures for taxes paid; and
(5) Coordinate with foreign subsidiaries and withholding agents to obtain the appropriate documentation for both current and future FTCs.
Alvarez & Marsal Taxand Says:
Every company’s situation is different. To succeed, you will need to build a custom tailored collection system that addresses your business’s specific challenges and risks. The system will need to align the goals of various groups (including sales, finance and operations) with the goals of the tax group ultimately responsible for proper substantiation. With potentially millions of dollars of FTCs on the line, we recommend building incentives and safety measures to ensure that all necessary documents are collected and appropriately stored.
The ideal FTC substantiation system should be self-sustaining and “IRS ready,” with an ability to provide prompt substantiation on short notice for all credits claimed. Importantly, the system must be able to track FTCs down to the individual transaction and provide information on every accrual. Finally, the system should be scalable and user-friendly for all groups involved.
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.