Recently, the federal government provided some relief to suffering businesses through the extension of the net operating loss (NOL) carryback. In a previous edition of Tax Advisor Weekly (, November 19, 2009), we noted that the carryback of a net operating loss would require a recalculation of the foreign tax credit limitation in those earlier years. As part of that analysis, or even apart from it, taxpayers may have the opportunity to re-evaluate decisions made in earlier years with respect to foreign taxes.
Taxpayers who have been subject to a foreign tax liability (either directly or indirectly) are provided a mechanism for reducing the effects of double taxation. There are two options available: the deduction of foreign taxes paid and the credit against U.S. income tax. While a credit is always more valuable, the U.S. foreign tax credit regime and the complicated application of theory to facts often result in the inability to fully credit foreign taxes. In those instances, a deduction may at least allow a taxpayer to offset some of the double taxation.
You may be asking why this is relevant right now. For the tax years beginning before October 22, 2004 (including calendar years 2003 and 2004), the foreign tax credit could be carried back two years and forward five years — although this carryforward period was later extended. Taxpayers may have a much different view of the carryback and carryforward period for these years in light of the special five-year NOL carryback provision for calendar 2008 and 2009 tax years, or due to the significantly changed business landscape since 2007. Taxpayers may be facing the possibility that these credits could expire before they get a chance to use them. If you elected to credit foreign taxes in those years, it is possible that deducting those taxes may be the better option. Luckily, the special statute of limitations under Internal Revenue Code Section 6511(d)(3) allows taxpayers a 10-year window within which to make the “deduct or credit” decision.
Here are some situations when you may want to deduct, rather than credit, foreign taxes:
- Your 2008 or 2009 net operating loss is a foreign source loss. Remember that when you have a net operating loss you must determine the sourcing (domestic or foreign) of losses, whether you want to or not! Foreign source losses must first offset foreign source income in a carryback year. The 2008 or 2009 loss may only offset 50 percent of 2003 or 2004 taxable income, but if your carryback loss is foreign source, it would offset the foreign source income before domestic source income, potentially eliminating the ability to credit foreign taxes in the earlier year.
- You elected to credit foreign taxes with the expectation of future foreign source income that didn’t materialize. Projections tend to be rosier than reality, and this was especially true when the global economy began souring in 2007. It may be that your projections of foreign source income have turned out to be inaccurate, and now you are left with foreign tax credits that have expired or will expire unused.
- The year that you are carrying back to was a year in which you used a foreign tax credit. For years other than the fifth preceding year, the net operating loss carryback can offset 100 percent of taxable income. That means no U.S. tax against which to credit foreign taxes. If the carryback of the 2008 or 2009 loss eliminates all the taxable income during the foreign tax credit carryforward period, the tax credits may now expire unused.
- Other impacts of the bad economy have reduced or eliminated your ability to claim a foreign tax credit. The most common hurdle for taking a foreign tax credit is the apportionment of interest expense to foreign source income. The worsening economy may have increased borrowing costs and reduced income to the point that you now are unable to credit taxes because of an overall foreign loss.
There are various other scenarios that can affect the foreign tax credit calculation, and often these are not readily apparent when taxpayers make high-level decisions on the credit versus deduction question. It may seem like a no-brainer, but it might not be! In these situations, changing the election to deduct instead of credit the foreign taxes may allow you to increase a loss carryforward to future years, or create a loss that can be carried back even farther. While a deduction is never as valuable as a credit, it is more valuable than an expired credit.
Alvarez & Marsal Taxand Says:
The interplay of foreign tax credits should be modeled to determine the optimal decision on a year-by-year basis. Remember that crediting or deducting one year’s taxes does not impact the ability to make that decision for another year. When assessing the value of a planned net operating loss carryback, make sure to factor in any possible loss or reduction in your foreign tax credits. Make an educated decision to deduct or credit foreign taxes, and assess the opportunity to carry back credits that are “freed up” by the carryback claim. Neglecting this analysis could result in misstated financials or a missed opportunity to maximize your recovery of foreign taxes.
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.
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