- 4.61.10 Foreign Tax Credit
- 22.214.171.124 Foreign Tax Credit Audit Guidelines
- 126.96.36.199.1 1986 Law Changes
- 188.8.131.52 Eligible Taxpayers
- 184.108.40.206 Eligible Foreign Taxes
- 220.127.116.11.1 Credit Applicable Only to Taxes
- 18.104.22.168.2 Tax Must Be Based on "Income"
- 22.214.171.124.3 Taxes "In Lieu of" Income Taxes
- 126.96.36.199.4 Denial of FTC for Certain Countries
- 188.8.131.52.5 Payment or Accrual of the Foreign Tax
- 184.108.40.206.6 Deemed Paid Credit
- 220.127.116.11.6.1 Requirements
- 18.104.22.168.6.2 Source of Credit
- 22.214.171.124.6.3 Indirect Credit Audit Techniques
- 126.96.36.199.7 Deemed Paid Credit Computation
- 188.8.131.52 Substantiation Requirements
- 184.108.40.206 Election of FTC
- 220.127.116.11.1 Changing the Election
- 18.104.22.168 Calculating Creditable Tax
- 22.214.171.124 Changes in the Amount of Foreign Taxes Claimed
- 126.96.36.199 Earnings and Profits (E&P)
- 188.8.131.52.1 Computing E&P
- 184.108.40.206 FTC Limitation
- 220.127.116.11.1 Classifying Income into Categories
- 18.104.22.168.2 Carryback and Carryover of Excess Credits
- 22.214.171.124.3 Statute of Limitations on Carryback Years
- 126.96.36.199.4 Special Sourcing Rules
- 188.8.131.52 Taxable Income and the FTC
- 184.108.40.206.1 Expenses Related to Foreign Source Income
- 220.127.116.11 General Audit Guidelines
- 18.104.22.168 Code Sections Affecting Credit for Foreign Taxes
- 22.214.171.124 Alternative Minimum Tax Considerations
- Exhibit 4.61.10-1 Direct Taxes Audit Techniques
- Exhibit 4.61.10-2 Indirect Taxes Audit Techniques
- Exhibit 4.61.10-3 Comparison of Indirect Credit Computations
- Exhibit 4.61.10-4 Categorization Conflict Resolution Rules
- Exhibit 4.61.10-5 Internal Revenue Code Sections Dealing with Foreign Taxes
Part 4. Examining Process
Chapter 61. International Program Audit Guidelines
Section 10. Foreign Tax Credit
The purpose of the Foreign Tax Credit (FTC) is to provide relief from double taxation. Double taxation may occur, for example, when the U.S. taxes foreign sourced income. FTC limits the overall tax rate on foreign sourced income to the higher of the taxpayer's foreign or U.S. tax rate. The United States does not impose additional tax on foreign income when the foreign tax rate is higher than the U.S. rate. Conversely, if the tax rate on the foreign sourced income is lower than the U.S. tax rate, the FTC causes the overall tax on the foreign income to approximate the U.S. rate.
This table summarizes the Code sections that authorize and limit the FTC:
Summary of IRC Sections Authorizing and Limiting the FTC
Code Section Description 901 Allows direct credit for taxes paid to a foreign country by a U.S. taxpayer based on realized net income. 902 Allows deemed paid or indirect credit for foreign taxes based on the proportion of taxes paid by a corporation on its distributed earnings and profits. 903 Allows direct credit for taxes (typically foreign withholding taxes based on gross receipts) and paid "in lieu of" the generally imposed net income tax. 904 Limits the amount of credit available in each year, including carryovers of credit. 905 Provides guidelines on foreign tax adjustments, redeterminations and proof of credits. 906 Allows the foreign tax credit for nonresident alien individuals and foreign corporations engaged in a trade or business in the United States. 907 Contains credit limitation for foreign oil and gas income. 960 Allows an indirect credit for deemed distributions.
There are two types of FTCs.
Direct credits are for taxes withheld or taxes paid on the profits of a foreign branch.
Indirect or deemed paid credits are for taxes paid by foreign corporations with 10 percent U.S. shareholders.
The FTC regime changed in 1986. For tax years after 1986, taxpayers must:
Maintain multi-year pools for undistributed earnings and taxes of foreign subsidiaries for purposes of calculating indirect credits
Categorize income into nine or more baskets, each with a separate limitation
The foreign source income categories are:
High withholding tax interest
Financial services income
Dividends from each noncontrolled IRC section 902 corporation [See IRM 126.96.36.199.1(5).]
Dividends from a DISC or former DISC
Taxable income attributable to foreign trade income
Certain FSC distributions
All other income (general limitation)
The taxpayer may have certain types of income segregated into additional baskets such as income from blacklisted countries and income treated as foreign sourced under a tax treaty. [See IRC section 901(j), IRC section 904(g)(10), 246(a)(10), and IRC section 865(h)(1)(B). ]
IRC section 904(d) provides that the FTC limitation of IRC section 904(a)–(c) applies separately to the income in each basket.
If a distribution is from pre-1987 earnings, the old rules apply. Pre-1987 earnings and profits and taxes use a separate calculation for each year. After the 1986 Act, taxpayers maintain "undistributed earnings and taxes pools" for each foreign subsidiary.
The first step in an FTC examination is to assess the taxpayer’s eligibility for the credit. Taxpayers subject to U.S. taxation on foreign sourced income are generally entitled to the FTC.
US. citizens and domestic corporations may generally claim a credit for the eligible foreign taxes they pay or accrue. Foreign taxes paid on the following types of income, that are generally exempt from U.S. taxation in the hand of U.S. citizens, are not eligible for a FTC.
Income from sources within possessions of the United States by certain bona fide residents of the possession [see IRC sections 931, 932, and 933]
All excluded foreign earned income [See IRC section 911(d)(6)]
Foreign corporations and Individuals and corporations residing in a U.S. possession (except Puerto Rico) that are not otherwise citizens and not residents of the United States are generally not subject to tax on non-US source income and so are not entitled to the FTC .
Resident aliens in the United States are subject to U.S. taxation and are, therefore, eligible for the FTC. The following limitations apply:
The general rules applicable to U.S. citizens apply to this category of taxpayers.
Only those foreign taxes on income earned while in the status of a resident are eligible for credit (consult the specific treaty involved).
Aliens residing in U.S. possessions (excluding those in Puerto Rico for the entire year) do not get the benefit of the FTC since they are not generally subject to U.S. taxation on non-U.S. source income.
Nonresident aliens and foreign corporations are eligible for FTC relating to qualified taxes paid on foreign source income effectively connected with a U.S. trade or business (See IRC section 906). A flat 30 percent tax (or lower treaty rate) applies to investment and other fixed or determinable periodical income whether or not the recipient engages in a trade or business in the United States.
Taxes paid to U.S. possessions by U.S. citizens and resident aliens are eligible for credit. "U.S. possessions " include Puerto Rico, Guam,the Northern Mariana Islands, American Samoa and the Virgin Islands for the purposes of the foreign tax credit. A credit under IRC section 30A and 936 (possession credit) is available to certain corporations that claimed the credit in 1995. The possession credit is an elective alternative to the FTC (See IRM 4.61.).
Other taxpayers eligible for the FTC are:
Exempt organizations with unrelated business taxable income [IRC section 515]
Estates and Trusts [IRC section 642(a)(2)]
Domestic Insurance Companies [IRC section 841]
Partners in partnerships [IRC sections 901(b)(5) and 702]
Shareholders of Regulated Investment Companies [IRC section 853]
Ten Percent Domestic Corporate Shareholders of Controlled Foreign Corporations, Noncontrolled Foreign Corporations and Passive Foreign Investment Companies [See 4.61.7, Controlled Foreign Corporations, for special rules]
Shareholders of Foreign Investment Companies [IRC section 1247(f)]
Shareholders of S Corporations [IRC section 1373(a)]
For income tax liability and return filing requirements pertaining to specific possessions, see IRC 931 - 33 and 935.
Only foreign income, war profits, and excess profits taxes qualify for FTC [See IRC section 901(b).]
To be creditable, a foreign tax must be:
A compulsory payment to a foreign government, and
An income tax, or a tax in lieu of an income tax
Tax on income in the U.S. sense is a tax on net gain. A tax is likely to reach net gain if it meets three criteria:
Realization test (imposed generally when income is "realized" under the Internal Revenue Code)
Gross receipts test (based on the fair market value of amount realized)
Net income test (gross income is reduced by expenses)
The following are examples of payments not creditable as taxes.
Penalties, interest, fines and custom duties
Amounts reasonably certain to be refunded, credited, rebated, abated, or forgiven
Principles of U.S. law determine whether a payment is a tax. A payment to a foreign country is not a tax if the payor receives, or will receive, a specific economic benefit in exchange for the payment.
Soak-up taxes are not creditable. A soak-up tax means that the U.S. taxpayer is liable for the tax only to the extent that the tax is creditable.
Check a tax research service containing a list, by country, of qualifying income taxes. An unidentified tax might be a sales, turnover, transaction, output, production, asset or property tax not qualifying for credit. Value Added Taxes (VATs) and Goods and Services Taxes (GST's) do not qualify for credit.
The Internal Revenue Bulletin contains the latest creditability determinations.
A tax "in lieu of" an otherwise generally imposed tax on income must be a tax within the meaning of Reg. 1.901–2(a)(2) and meet the substitution requirements of Reg. 1.903–1(b).
The FTC is denied for taxes paid to countries with which the United States has severed diplomatic relations or which are designated as supporting international terrorism. [See IRC section 901(j)]
Taxes paid to certain countries specified in IRC 901(j) are generally not creditable for years beginning after December 31, 1986 (See Rev. Rul. 95–63 and IRC section 901(j)].
A U.S. taxpayer that pays tax to a foreign country may claim a direct credit on either the cash basis or the accrual basis, subject to the limitations described below.
The term "direct tax credit" applies to foreign taxes paid outright by a U.S. taxpayer. Either the person claiming the credit or a withholding agent may make the actual payment. The foreign tax must be the liability of the person claiming the credit.
Audit techniques applicable to the review of direct taxes are presented at Exhibit 10–1.
Indirect credit is a computed amount of credit related to an actual or deemed distribution to an eligible corporate shareholder. The amount of the credit is proportionate to the amount of foreign income taxes the corporation making the distribution paid on its Earnings and Profits (E&P). The term indirect (or deemed paid) credit refers to the fact that the foreign income tax is paid by the foreign subsidiary.
There are several prerequisites to claiming an indirect credit from a first tier foreign corporation.
The U.S. shareholder must elect to claim the FTC.
The U.S. shareholder must own at least 10 percent of the voting stock of the first tier foreign corporation.
The U.S. shareholder must have an actual or deemed dividend.
The foreign corporation must have paid an income tax.
The U.S. shareholder must include in income the IRC section 78 gross up.
Indirect credits result from either:
Dividends received (cash or property) from a foreign affiliate per IRC section 902
Deemed dividends reported under IRC section 951 from a controlled foreign corporation per IRC section 960
As long as the U.S. shareholder meets the ownership requirements of IRC section 902(b) or 960(a)(1), it may claim deemed paid credits for taxes paid by a second or third-tier corporation. For taxable years beginning after August 5, 1997, indirect credits are also available for fourth-, fifth-, or sixth-tier foreign corporations that are controlled foreign corporations. In order to claim FTC from a lower tier, a U.S. shareholder must meet all of the following conditions.
The first-tier foreign corporation must own at least 10 percent of the voting stock of the second-tier foreign corporation.
The U.S. shareholder must own indirectly at least 5 percent of the voting stock of the lower tier corporation.
The other corporation may not be below the third tier (or, for post-1997 years, the sixth tier).
To compute an indirect credit from a lower tier, use the same formula that is used to compute an indirect credit from a first-tier subsidiary (see IRC section 902(b)).
Many of the problems encountered in verifying indirect taxes are similar to those met in verifying direct taxes. For suggested audit techniques, see those applicable to direct taxes at Exhibit 4.61.10–1. Exhibit 4.61.10–2 contains techniques for auditing deemed paid credits.
IEs verifying deemed paid credits must be alert for the following issues:
Credits based on accrued taxes as opposed to actual tax payments,
Credits based on gross income taxes, without reduction for credits and rebates
Credits based on non-income taxes (e.g., taxes similar to our FICA tax if based on beneficiary's age, life expectancy, or similar factors)
Credits based on payments of tax that include an inflation factor (this mainly applies to indirect credits from Brazil; see Rev. Rul. 91–21 if you have this pre-1997 issue)
Claims based on lower-tier credits, even though there have been no dividends paid by the lower tier, or the shareholder fails the 5% indirect ownership requirement
Claims for indirect credit based on distributions excluded from income under IRC section 959 (amounts previously taxed under Subpart F)
Omission of the IRC section 78 dividend income (gross up) for the indirect credit claimed
Techniques for auditing deemed paid taxes include:
Requesting supporting documentation from the taxpayer
Sampling transactions to test the quality of a taxpayer’s record keeping and reporting systems
The following information may be necessary when verifying the E&P and taxes.
A detailed breakdown, by year, of the post-1986 undistributed earnings and tax pools including the dates of payment of the taxes, and the exchange rates used to convert to U.S. dollars.
The reporting packages regularly sent to the taxpayer by the foreign affiliate, or prepared by the taxpayer for each affiliate. These packages should include: Adjustments made by the entity to convert the statements to U.S. GAAP; Detailed schedules on reserves, miscellaneous accruals, and accounts payable; Subpart F schedules; and internal financial statements.
The detailed audited financial statements, including all footnotes, translated into English.
A detailed list of all adjustments to U.S. tax and accounting standards made by the taxpayer (including detailed computations). This may be part of the tax package, which contains all adjustments made by the taxpayer’s U.S. tax department.
A trial balance for both the beginning and ending of each year is useful in reviewing changes in reserve balances.
A detailed schedule of miscellaneous accruals and/or accounts payable may be an adequate substitute.
The foreign income tax return, with pertinent portions translated into English including: The taxable income line; The tax computation schedule showing credits and payments; The reconciliation of book to return (similar to the schedule M).
Proof of payment of the income taxes [should tie to the liability in (e) above]
Tax assessment notices showing any adjustments to the return amounts
Translated copies of reports for audits done by foreign governments
The Tax Reform Act of 1986 completely revised the deemed paid foreign tax credit rules contained in IRC section 902. The regulations became final on January 6, 1997.
While the majority of dividends are sourced from the pools required to be kept after the Tax Reform Act of 1986 (post-1986 pools), it is still necessary to be aware of the rules applicable to dividends sourced from pre-1987 years for two reasons.
Distributions of pre-1987 E&P or E&P accumulated before there was a 10 percent U.S. shareholder are still characterized under the old rules.
While the general theory of the indirect credit has not changed, the mechanics of the computations are different.
The formula for deemed paid FTC for distributions sourced from pre-1987 years is:
Foreign Tax x Dividend = FTC Accumulated E&P
Under the pre-1987 law, the FTC calculation uses annual accumulated profits.
There are specific rules to follow regarding the years to which the dividends apply and the order of the application.
Dividends reduce the E&P of a specific year on a last in first out basis.
If a dividend is paid out of the accumulated profits of more than one year, separate computations are necessary for each year.
Prior to 1987, taxpayers were able to use the annual computations to cycle their earnings and distributions in order minimize U.S. tax. Subsidiaries with E&P deficits must carry back deficits and reduce the profits of earlier years per Rev. Rul. 74–550. This may result in the permanent loss of credit for the foreign taxes paid in a carryback year. To eliminate the timing advantages and mitigate the harshness of the NOL carryback rule, the computation for years after 1986 combines all post-1986 earnings and deficits.
The formula for deemed paid foreign tax credit (FTC) for distributions sourced from the post-1986 pools are:
Post-1986 Foreign Tax Pool x Dividend = FTC Post-1986 Accumulated E&P Pool
Under the post-1986 law, the FTC computation uses profits accumulated after 1986. The table at Exhibit 18–3 summarizes the computational changes.
Creditable foreign taxes are no longer translated using the exchange rate in effect on the date of the dividend. The U.S. dollar tax pools now record all:
The translation rules are:
For tax years after 1997, accrual basis taxpayers generally use the average exchange rate for the year. [See section 986(c)].
For pre-1997 taxes and taxes paid more than two years after the year to which they relate, use the spot rate on the foreign tax payment date
Refunds are translated at the rate used to translate the original payment [See section 986(a) and Reg. 1.905-3T(b)(2)]. Use the last-in-first-out approach for lump sum refunds related to different payments. [See Reg. 1.905-3T(b)(3)].
Distributions that exceed the post-1986 earnings reduce the pre-1987 accumulated profits, on a separate year basis, using the latest year first.
The indirect credit formula is the same for dividends from lower tier subsidiaries. The computations of the earnings and tax pools of lower tier subsidiaries are similar to those required of the first tier foreign corporation. Foreign taxes attributable to distributions from lower tier subsidiaries increase the tax pools of upper tier subsidiaries (the distributions are already in their E&P). The following summary highlights the rules applicable to distributions sourced from post-1986 pools when there are multi-tier foreign subsidiaries involved.
Earnings are recorded in the functional currency of the lower tier subsidiary. [See IRC section 986(b)].
E&P is adjusted to U.S. accounting and tax standards [See IRC section 964(a)].
The E&P pool is reduced for prior year but not for current year dividends.
The tax pool includes current year taxes and is reduced by all post-1986 indirect credits on dividends and inclusions paid in prior years.
IRC section 905(b) requires that a taxpayer substantiate its FTC. Substantiation includes, but is not limited to, the following items:
Translated tax returns and payment receipts
A copy of relevant foreign tax law
Audited financial statements on U.S. tax and GAAP basis
Translated examination reports
Relevant tax treaties
For guidance on evidence that is acceptable to establish the creditability of foreign taxes, see Reg. 1.905–2 and Rev. Rul. 67–308, 1967–2 C.B. 254. In order to prove that the taxes claimed are proper, the taxpayer must supply the original, a duplicate original, a duly certified or authenticated copy, or a sworn copy of:
Receipts for each claimed tax payment
Returns that are the basis of any tax accruals
The regulations require that the taxpayer provide certified translations of receipts and returns.
Reg. 1.905–2(b) describes secondary evidence as evidence other than the actual receipt and tax return. Secondary evidence is only admissible if the taxpayer can establish to the satisfaction of the examiner that it is impossible to produce the receipt and or return.
Taxpayers may apply for a prefiling agreement on the adequacy of secondary evidence. See Rev. Proc. 2001-22
Taxpayers have an annual choice of electing FTC or deducting foreign taxes. Taxpayers may claim a credit in one year and a deduction the following year, or vice versa.
Attaching a completed Form 1116 or 1118 to a U.S. tax return constitutes an election to take the FTC. An election by one member of a consolidated group binds all the corporations joining in the consolidated return. In the absence of an election, taxpayers may deduct foreign taxes meeting the requirements for deductibility under IRC sections 162 & 164.
Foreign taxes not qualifying for credit are deductible in the same year qualifying foreign income taxes are creditable.
Taxpayers electing FTC may not take a deduction for any portion of the qualified foreign taxes for the taxable year. However, a computation of a net operating loss carryback or carryover may properly include a deduction for foreign income taxes
Taxpayers may change or make their election at any time during the period that they may file a claim for credit or a refund. See IRC section 6511(d)(3) for a special rule extending to 10 years the statute of limitations for filing a refund claim attributable to foreign tax credits.
A qualified foreign tax is creditable when paid or accrued depending on the taxpayer’s method of accounting.
IRC section 905(a) allows cash basis taxpayers to claim credits for foreign taxes on the accrual basis.
For accrual basis taxpayers, IRC section 986 generally calls for the conversion of foreign taxes into U.S. dollars based on the average exchange rate for the year of the actual payment
Special conversion rules apply where
taxes are paid more than 2 years after the taxable year to which taxes relate
taxes are paid before the year to which the taxes relate
taxes are subsequently adjusted.
For cash-basis taxpayers, taxes are converted into U.S. dollars based on the exchange rate on the date of payment.
A cash basis taxpayer may elect to claim foreign tax credits using the accrual method. Once the accrual method is elected it must be used in all subsequent years.
Taxes accrue when all events occur that fix the amount of the tax. Economic performance is not generally required. Reg. section 1.461-4(g)(6)(iii)(B).
The Dixie Pine Products Company case addressed the issue of when the contested foreign taxes accrue for deduction purposes ( 44-1 USTC ¶9127, 320 U.S. 516, 64 S. CT. 364). The Court held that a contested tax accrues and is deductible only in the later year when there is a final determination of liability. However, this rule does not apply to the accrual of foreign taxes for FTC purposes. Once accrued, foreign taxes will relate back and may be claimed as credits in the tax year with respect to which the disputed tax is paid. See Rev. Rul. 84-125, 1984-2 C.B. 125; Cuba Railroad Co., 124 F Supp 182 (1954).
If a taxpayer chooses to deduct foreign taxes, an accrual does not relate back to the year a tax is in dispute.
IRC section 905(c) and Reg. 1.905–3 require taxpayers to notify the Service of changes in taxes paid or accrued.
For cash basis taxpayers and where taxes are paid more than two years after the year to which they relate, the translation of tax payments is performed using the spot rate (i.e., the exchange rate on the date of payment). Conversion of refunds is based on the original payment dates [See IRC section 986(a)].
Taxpayers failing to notify the Secretary of a foreign tax redetermination are subject to penalties under IRC section 6689. If there are any previously undisclosed changes identified during the audit, ask the taxpayer to explain. An exception exists for taxpayers who can show that their failure to notify is due to reasonable cause.
There is a ten-year statute of limitations for filing a refund claim when a U.S. taxpayer pays foreign tax relating to an earlier year. There is no statute of limitations when a foreign tax refund results in a U.S. tax liability and the taxpayer fails to notify the Secretary [See IRC section 905(c), Pacific Metals Corp., 1 TC 1028; and Texas Co. (Caribbean) Ltd., 12 TC 925]
Section 905(c) and Reg. 1.905–3T(c) define a Foreign Tax Redetermination (FTR) as a change in a foreign tax liability that may affect a U.S. taxpayer’s foreign tax credit. The term FTR includes:
Additional tax assessments
For cash basis taxpayers and pre-1997 years, differences between the dollar value of the accrued foreign tax and the dollar value of the foreign tax actually paid attributable to fluctuations in the value of the foreign currency relative to the dollar between the date of accrual and the date of payment
Failure to pay an accrued tax within two years after the year to which the tax relates.
If the original tax is specifically related to a given category (basket) of income, then the refund shall be applied to that category of income.
An FTR of a direct foreign tax credit requires a correction to the original return. For taxable years prior to 1998, a current year adjustment of an FTR that is solely the result of currency fluctuations is permissible, but only if the adjustment is the lesser of:
2 percent of the total amount of the foreign tax initially accrued with respect to that foreign country for the taxable year
A refund of a direct FTC that is converted into dollars will create an exchange gain or loss in the year the refund is received, in an amount equal to the difference between the dollar value of the refunded tax when the credit was claimed and the dollar value of the refund.
When there is an FTR to an indirect foreign tax credit, adjust the tax pool and E&P pool in the year of the FTR. Exceptions to this rule are:
If there is a (an): Then the taxpayer must: Adjustment to pre-1987 years occurring after 1986 Carryback all FTRs Refund of tax causing a deficit in tax pool Carryback all FTRs; no exceptions. 1.905-3T(d)(4)(iv) Tax accrued in hyperinflationary currency Carryback all FTRs; no exceptions. 1.905-3T(d)(4)(i) Over accrual of tax of 2 percent or more Carryback FTRs at the Service’s discretion. 1.905-3T(d)(4)(ii) Tax refund resulting from a distribution of previously taxed Subpart F income Carryback all FTRs. 1.905-3T(f)
When an FTR results in a redetermination of the U.S. tax liability, the taxpayer must comply with the Notice and Redetermination requirements of Reg. 1.905–4T. An FTR of an indirect FTC that does not require a redetermination of the U.S. tax liability may still be subject to reporting requirements [See Reg. 1.905–3T(d)(2) and Notice 90–26].
Interest is restricted on a deficiency created by a refund of foreign tax until the date of the refund. Exception: If the foreign country paid interest on the refund, interest can be collected on the deficiency up to the amount that could otherwise be assessed under IRC § 6601. See Treas. Reg. § 1.905-4T(c).
The U.S. dollar is the base for U.S. income tax while foreign currency is the base for foreign tax. Therefore, the tax credit decreases or increases when the foreign currency depreciates or appreciates.
Subject to revisions for taxes paid or accrued after 1997, this table summarizes the rules for accruing foreign taxes:
If: The exchange rate will be: A taxpayer files its U.S. return on the cash basis The rate in effect on the date of payment of foreign taxes. A taxpayer files its U.S. return on the accrual basis The rate in effect on the last day of the year.
The amount of credit claimed for accrued tax is provisional. Required adjustments arise when the exchange rate for accrual differs from the exchange rate at the time of payment.
New Rules for Post-1997 Years . For taxes paid by cash basis taxpayers after 1997, section 986(a) authorizes regulations providing for the use of average exchange rates. Taxes claimed as credits on the accrual basis are translated at the average exchange rate for the year of accrual. However, the credit for an accrued tax must be revised if the tax is not paid within two years after the accrual year. If subsequently paid, such a tax will be translated at the rate in effect for the year paid but may be claimed as a credit for the prior year to which the tax relates.
FTC allows the U.S. taxpayer a dollar for dollar credit against a taxpayer’s U.S. tax liability. The limitation on the amount of credit assures that the U.S. tax liability is reduced only on foreign sourced income.
IRC section 904 categorizes foreign income and limits the FTC to the amount of the U.S. income tax attributable to the foreign sourced taxable income in each category. The limitation is:
Foreign Sourced Category ____________________ X U.S. Income Tax before other credits = FTC Limitation Total Taxable Income
The relationship between the limitation and the FTC are illustrated in the following table:
If the IRC section 904(a) limitation: Then the taxpayer may use: Increases More FTCs Decreases Less FTCs
The income and foreign taxes from one category (basket) cannot be combined with the income and foreign taxes from another category. An explanation of the income to be assigned to each basket is at Reg 1.904–4. Certain types of income satisfy the definitions of two or more baskets. The regulations contain rules to resolve these issues. Exhibit 10–4 summarizes the conflict resolution rules. Income that does not meet the definition of any of the first eight baskets goes into the general limitation basket.
IRC section 901(j) denies the FTC for taxes paid to foreign countries with whom the United States has severed diplomatic relations (See IRM 188.8.131.52.4). Income from these countries is put in a separate basket to prevent it from being offset by taxes paid to other countries.
Taxpayers subject to Alternative Minimum Tax (AMT) must compute both a regular foreign tax credit and an AMT foreign tax credit. Separate IRC section 904(a) limitations, carryforwards and carrybacks apply to the regular FTC and the AMT FTC.
For purposes of the FTC limitation computation, IRC section 904(b)(4) provides that taxable income does not include the taxable income taken into account for the IRC section 936 possession credit.
Treatment of dividends from non-controlled section 902 corporations varies depending upon dates of payment and earnings. For dividends paid prior to 2003, dividends from each such corporation are placed in a separate basket. All dividends paid after 2002 out of pre-2003 earnings are placed in a single basket, regardless of the number of corporations making such distributions. Finally, dividends paid out of post-2002 earnings are treated on a look-through basis and assigned to baskets based on the underlying nature of the payor's activities. For this purpose, dividends are generally deemed paid out of earnings on a last-in-first-out basis. See Notice 2003-5, 2003-1 C.B. 294.
Taxpayers unable to fully use all of their available credits due to the FTC limitation may carry unused credit back two years and forward for five years [See IRC section 904(c)].
There is no credit carryback or carryover to years in which taxes are deducted. Any unused foreign taxes that are eligible for carryback or carryover to a year that foreign taxes are deducted are absorbed as though the taxpayer had elected to take the credit for foreign taxes paid in that year.
Excess credit is not deductible in any year, even if creditable taxes are deducted that year.
If unused foreign tax credits are carried back, the statute of limitations for the year to which the carryback is utilized will not close until one year after the statute has expired for the year in which the carryback originated [See IRC section 6501(i).]
Statutes related to foreign tax changes are detailed in IRM 184.108.40.206.
Under the general sourcing rules of IRC sections 861 and 862, dividends and interest received from a foreign corporation are foreign sourced income. However, when a significant portion of the foreign corporation’s income is from U.S. sources, the normal sourcing rules may not apply [See IRC section 904(g)].
The following table summarizes the sourcing rules.
Summary of the Sourcing Rules
Income from U.S. owned foreign corporations in the form of: Will be treated as: No sourcing where: Deemed, but not distributed: U.S. source income, to the extent of: NO EXCEPTIONS • Subpart F income
• Foreign personal holding company income
• An electing PFIC
U.S. Source E&P
Dividend income U.S. source income, to the extent of: The U.S. source E&P is less than 10 percent of total E&P U.S. Source E&P
Interest paid to either a:
• Related person
• A U.S. shareholder
U.S. source income, to the extent "properly allocable" per IRC section 904(g)(3)(C). The U.S. source E&P is less than 10 percent of total E&P
The numerator of the FTC limitation computation is foreign source income subject to U.S. income tax reduced by expenses and deductions directly or indirectly attributable to the production of such income.
The taxable income computation applies the provisions of IRC section 861 (income from sources within the United States) and IRC section 862 (income from sources without the United States). IRC section 863 contains methods for determining foreign source income when IRC section 861 or 862 does not apply. It also applies to manufacturers of products in the United States when title to the products passes outside the United States and vice versa, or when natural resources are involved. IRC section 865 provides rules for sourcing income from sales of personal property.
Forms 1116 for individuals and 1118 for corporations are an excellent guide for the IE. These FTC forms must reconcile with other areas of the tax return. The following items on the Form 1118, when present, will tie to other areas on a tax return.
Foreign sourced income (dividends, interest, rents, royalties, Subpart F, etc.)
IRC section 78 gross up
IEs will consider the following audit procedures when verifying taxes:
Review the E&P and tax pools
Check the exchange rates used in converting E&P and taxes
Verify that E&P is computed using GAAP and U.S. tax standards
Consider Rev. Rul. 76–508 and 80–231 and Reg. 1.901–2(e)(5) in cases involving IRC section 482 adjustments
Ensure the reporting of the IRC section 78 gross up
Determine that all qualifying foreign taxes are in the FTC computation and that none are treated as deductions (or vice versa if the taxpayer chooses not to take the FTC)
Review all FTC related elections
Ensure that there is no double counting of taxes resulting from claiming both the accrual and payment of foreign taxes
Determine if the taxpayer has filed a claim for refund or credit when auditing years with excess FTC
Review the substantiation requirements at Reg. 1.905–2 and Rev Rul. 67–308.
Verify that the taxpayer is reporting the gross income with respect to income subject to withholding.
Consider that a taxpayer in or near the FTC limitation may try to increase Foreign Sourced Income (FSI) and decrease the allocation and apportionment of expenses to FSI. The application of IRC section 482 has the potential to change FSI.
Ask the taxpayer to provide information on any changes in taxes paid or accrued.
Check to see if the taxpayer used the spot rate in converting pre-1987 foreign tax refunds (Rev. Rul. 58–237).
Make a reasonable cause determination and consider application of accuracy penalties.
Technical assistance on the creditability of a tax can be obtained from the office of the Associate Chief Counsel (International), or the International Technical Advisor (ITA) for this subject.
The following table provides suggested resolutions to examination difficulties.
If the taxpayer... Then consider... Procrastinates in providing documentation to support credits claimed Using Formal Document Requests per IRC section 982 Provides the documentation, but it has not been translated into English Using IRC section 905 and Reg. 1.905–2(a)(2) to force taxpayers to translate under threat of disallowance Claims credits for taxes they were not liable for Carefully analyzing receipts and tax returns to ensure the liability is for the taxpayer under examination Claims credit for taxes they paid but were later refunded (or they are refundable) Reviewing treaty for proper tax rates or reviewing tax returns for actual liability Claims credits for amounts which are not income taxes or other creditable taxes Making sure receipts and returns are translated and clearly designated as income taxes or other creditable taxes Claims credits for accrued taxes Asking for actual tax receipts and returns Claims credits for payment of branch income taxes based on the end of year exchange rate instead of the dates actually paid or average rate Verifying actual dates paid, method of payment and proper exchange rate(s) Claims the gross income tax assessed on branch profits, even though the foreign government allows the branch to offset the gross tax with credits Verifying actual receipts and tax returns (and translations if required) Claims credit for payment of branch income taxes Carefully reviewing Form 1118 and branch financial statements to determine if they are properly allocating expenses of the U.S. parent Reports the after-tax profit for the branch on form 1120 Grossing up the branch profits by the taxes paid Claims credits for taxes based on capital, and not net income Making sure receipts and returns are translated and clearly designated as income taxes Claims an FTC Review Schedule M for proper handling of credit and that the taxpayer did not also deduct the tax as an expense
Exhibit 4.61.10–5 details most IRC sections that impact the credit or deduction for foreign taxes.
Taxpayers are also entitled to foreign tax credits when calculating alternative minimum tax.
When calculating the AMT 904 limitation, the pre-credit tentative minimum tax is the tax against which such credit is taken for the taxable year and all prior taxable years beginning after December 3, 1986. Additionally, IRC 904 is applied on the basis of alternative minimum taxable income instead of taxable income and the determination of whether any income is high-taxed income is to be made on the basis of the tentative minimum tax rate determined in IRC 55(b)(1). IRC 59(a)(1).
The alternative minimum tax foreign tax credit for any taxable year shall be limited to 90 percent of tentative minimum tax (before consideration of alternative minimum tax net operating loss deduction and IRC 57(a)(2)(E)). IRC 59(a)(2)(A).
Alternative Minimum Tax Foreign Tax Credits in excess of the IRC 904 limitation have the same 2 year carryback and 5 year carryforward periods. However, because the amounts used in the IRC 904 limitation formula are different (pre-credit tentative minimum tax vs. regular tax and alternative minimum taxable income vs. regular taxable income), the credit carryback and carryforward have to be separately maintained for alternative minimum tax purposes
In the case of a taxpayer other than a corporation, the pre-credit tentative minimum tax is the amount determined under the first sentence of IRC 55(b)(1)(A)(i). In the case of a corporation, the pre-credit tentative minimum tax is the amount determined under IRC 55(b)(1)(B)(i). IRC 59(a)(3).
An election under IRC 59(a)(4) can be made for the first taxable year beginning after December 31, 1997 to simplify the IRC 904 limitation for purposes of the Alternative Minimum Tax foreign tax credit. The IRC 904 limitation shall be based on the proportion of the taxpayer’s foreign sourced taxable income for regular tax purposes (but not greater than the taxpayer’s alternative minimum taxable income) bears to the taxpayer’s alternative minimum taxable income. IRC 59(a)(4).
|Area to Review||Action|
|Accrued taxes||Request receipts and workpapers showing exchange rates to determine the accuracy of the credits claimed. Determine why an accrued tax remains unpaid at the time of the audit.|
|Note:||The foreign government may prohibit the payment of the income. Consequently, the tax credit based on this accrual should be disallowed until the income is no longer blocked [See IRC section 964(b)].|
|Taxes as a percentage of corresponding income||Compare the percentage paid to the treaty rate in IRS Pub. 901.|
|•||If the rate differs, ask the taxpayer to explain.|
|•||If you are at all uncertain as to what the tax is for, request that the taxpayer provide a copy of the foreign law translated into English.|
|Branch income taxes||Always request the taxpayer’s detailed schedule or workpapers showing the branch profits computation, and translated copies of the foreign income tax returns. With this information you can:|
|•||Verify that the taxpayer used the exchange rates for the dates of payment of the tax or the average rate for the years, whichever is applicable.|
|•||Verify that the tax claimed as a credit is the net tax, after all credits and abatements|
|•||Do a brief functional analysis to determine if some of the U.S. expenses are properly allocable to the branch|
|Method of accounting for credits||Is the taxpayer using the accrual or cash basis method of accounting? Check for consistency among periods.|
|Creditability of the tax||Determine that the tax:|
|•||Is based on income|
|•||Does not constitute a subsidy to the taxpayer|
|•||Meets the realization, the gross receipts, and net income tests|
|From the receipts and the foreign law, determine that the taxpayer:|
|•||Has not received an economic benefit|
|•||Is not likely to receive a refund or abatement|
|Withholding Tax||Match treaty rate with actual amounts paid.|
|Be alert to withholding on dividends as a matter of policy compared to the actual or final liability.|
|Example:||A tax paid in excess of a treaty rate is not a compulsory payment and would not be creditable.|
|Tax in lieu of an income tax||Determine if such a tax:|
|•||Constitutes a compulsory payment|
|•||Is a substitute for, and not in addition to, an income tax|
|Tax credit pools, or baskets||After you have determined the total allowable IRC section 901 tax credits, check baskets to see that the taxpayer has properly allocated them to the various baskets of income and taxes (e.g., general, passive, etc.).|
|Area to Review||Action|
|Computation of E&P||Review financial statements to ensure that the presentation conforms to U.S. accounting and tax standards. Consider denial of credit for failure to substantiate. After detail is obtained, closely scrutinize additions to reserves. Unrealized exchange gains and losses are not taken into account in computing E&P unless the foreign subsidiary operates in a hyper-inflationary environment and uses the DASTM method under Reg. 1.985–3.|
|Obtaining translated foreign government audit reports||Review the documents verifying taxes and E&P. Competent authority consideration is a prerequisite to the allowance of most foreign initiated adjustments.|
|Change||Pre-1987 Law||Post-1986 Law|
|Numerator||Distributions paid within the first 60 days of the year are sourced from the prior year.||No 60-day rule.|
|Denominator||Annual accumulated profits maintained in functional currency||Post-1986 undistributed earnings is a pool of all the undistributed earnings of the foreign corporation for all years beginning after December 31, 1986. The undistributed earnings must be:|
|•||Computed under IRC sections 964(a) and 986(b).|
|•||Reduced for dividends paid in prior years, but not for dividends paid in the current year|
|•||Maintained in functional currency|
|Multiplicand||Annual foreign income taxes maintained in functional currency||Post-1986 foreign income taxes is a pool of all foreign income taxes for the year of the dividend, and all prior years beginning after December 31, 1986. The pool is:|
|•||Reduced by all prior indirect credits and taxes attributable to earnings distributed to shareholders ineligible for indirect credits (e.g., foreign shareholders)|
|•||Maintained in U.S. dollars (See Reg. 1.902–1)|
|Income that satisfies the definition of:||And also satisfies the definition of:||Is treated as:|
|Passive||Any other category of income||The other category of income|
|High withholding tax interest||Any other category of income||High withholding tax interest|
|Financial Services||Shipping||Financial Services|
|Financial Services||Passive||Financial Services|
|Financial Services||Any other category except for shipping and passive||The other category|
|Shipping||Foreign trade Income||Shipping|
|Noncontrolled IRC section 902*||Any other category||Noncontrolled IRC section 902|
* Note: Look through rules apply to distributions out of earnings accumulated after 2002; distributions of earnings accumulated before 2003 will be aggregated in a single basket for distributions from all noncontrolled IRC section 902 corporations.
|33||Grants a credit against U.S. tax for taxes imposed by foreign countries and possessions of the United States to the extent provided in IRC section 901.|
|46(a)(4)||Prescribes the order and the tax liability against which credits are applied.|
|59(a)||Provides for the alternative minimum tax FTC.|
|78||Provides that a domestic corporation electing the foreign tax credit must gross up (i.e., increase) dividend income by the amount of creditable taxes associated with the dividends received.|
|114(d)||Disallows credit for foreign tax on excluded extraterritorial income.|
|164||Allows deduction for foreign income taxes if FTC is not claimed.|
|275(a)(4)||Prevents a taxpayer from deducting taxes and taking the FTC.|
|515||Allows the FTC, subject to the modifications, to be used against the tax of certain exempt organizations.|
|642(a)(1)||Provides that to the extent not allocated to the beneficiaries, an estate or trust shall be allowed the FTC.|
|691(b)||Provides the authority for the allowance of deductions and credits for recipients of income in respect of decedents.|
|702(a)||Provides that each partner shall take into account separately their distributive share of a partnership’s foreign taxes.|
|841||Allows the FTC, as modified, to be used in computing the tax of domestic insurance companies.|
|853||Allows the FTC, as modified, for shareholders of regulated investment companies if the company so elects.|
|861||Defines income from sources within the United States|
|862||Defines income from sources without the United States|
|863||Discusses sourcing of income not specified in IRC section 861 or 862.|
|865||Provides rules from sourcing income from personal property sales.|
|874(c)||Provides that the FTC is allowable to nonresident individuals only to the extent provided for in IRC section 906.|
|882(c)(3)||Provides that the FTC is allowable to foreign corporations only to the extent provided for in IRC section 906.|
|901||Grants a credit against the U.S. tax for taxes paid or accrued to any foreign country or to any possession of the United States and in the case of corporations, taxes deemed to have been paid under IRC section 902 and 960 are creditable.|
|902||Provides the methods for computing deemed paid taxes.|
|903||Provides that a credit may also be taken for taxes paid in lieu of the taxes.|
|904||Provides the method for computing the FTC limitation.|
|905||Sets forth the rules for the year that FTC is available. IRC section 905(c) provides that there is no statute of limitations on an additional U.S. income tax arising from a refund of a foreign tax where the taxpayer did not notify the Secretary. See IRC section 6689 for penalty applicable to IRC section 905(c).|
|906||Provides that nonresident aliens or foreign corporations engaged in a trade or business within the United States are entitled to FTC for foreign source income effectively connected with a U.S. trade or business.|
|907||Provides special rules for taxes on foreign oil and gas income.|
|908||Reduces the FTC for participation in international boycotts.|
|911(d)(6)||Denies FTC for taxes paid on excluded foreign earned income.|
|931(b) 933(i)||Provides that persons entitled to the benefits of IRC section 931 and 933 are not allowed FTC for tax on excluded income..|
|936 &30A||Allows the possession tax credit.|
|960||Permits FTC on Subpart F income.|
|1247(f)||Permits foreign investment companies to elect to distribute FTC to its shareholders.|
|1291(g) 1293(f)||Permits FTC with respect to PFIC inclusions|
|1373(a)||Permits FTC to shareholders of S corporations|
|1503||Prescribes special rules for consolidated returns.|
|6038(b)||Prescribes a reduction in allowable foreign taxes for failure to furnish certain information with respect to certain foreign corporations.|
|6501(i)||Sets forth the statute of limitations for assessment and collection of tax for foreign tax credit carrybacks (the one year rule).|
|6511(d)(3)||Provides special rules relating to the FTC in regard to limitation on credit or refund (the ten-year rule).|