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Select Foreign Tax Credit Impacts Pursuant to the Tax Cuts and Jobs Act

On December 20, 2017, the U.S. Congress passed the Tax Cuts and Jobs Act (the "Act"). The Act makes major changes to many areas of the Internal Revenue Code (“the Code”). This article summarizes the changes to the foreign tax credit system.

Background

U.S. citizens, residents, and domestic corporations are subject to tax on their worldwide income. In order to avoid double taxation of foreign source income, the U.S. utilizes a foreign tax credit (“FTC”) system that allows U.S. taxpayers to take a credit for foreign taxes paid or accrued on such income under section 901 of the Code.

There are two types of FTCs available to U.S. taxpayers – direct and indirect. Direct FTCs are credits for foreign income taxes paid by a foreign branch of a U.S. taxpayer, as well as foreign withholding taxes. Indirect FTCs are based on foreign income taxes paid by foreign subsidiaries and deemed paid by a U.S. domestic corporation that meets the ownership threshold (“DPC”). The foreign income taxes taken into account by a U.S. taxpayer under the indirect credit provisions are aggregated with any foreign income taxes paid directly by the U.S. taxpayer, such as withholding taxes on dividends to determine the foreign tax credit.

Repeal of section 902

The Act repeals the DPC system under section 902 and retains, with modifications, the DPC system under section 960. The repeal of section 902 of the Code has a substantial impact on domestic corporations currently eligible to claim a section 902 DPC with respect to dividends they receive from 10%-owned foreign corporations that are not CFCs because foreign income taxes paid or accrued by such corporations could no longer be claimed as FTCs. In lieu of FTCs, domestic corporations that meet the 10% ownership requirement will now be able to deduct the foreign source portion of dividends they receive from foreign corporations.

<h2class="customHeader">Determination of the section 960 credit on a current year basis and modification of the section 78 “gross-up” amount

U.S. shareholders of controlled foreign corporations (“CFCs”) are subject to special rules under sections 951 through 964. The subpart F rules require a U.S. shareholder of a CFC to include its pro-rata share of the CFC’s current earnings characterized as subpart F income.

The new definition of a “U.S. shareholder” will expand to include any U.S. person who owns 10% or more of the total value of shares of all classes of stock of a foreign corporation. Under prior law, the definition of a U.S. shareholder was limited to a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote. A CFC is any foreign corporation in which more than 50% of the vote or value is directly, indirectly, or constructively owned by U.S. shareholders on any day during the year.

Section 960 allows a corporate shareholder subject to the subpart F rules to take a FTC as if the shareholder had paid a portion of the foreign income taxes paid by the CFC. Individual shareholders of CFCs generally cannot claim an indirect credit under section 960. Under the Act, the allowable credit under section 960 will be based on current-year taxes attributable to subpart F income rather than the “pooling” approach that applied under prior sections 902 and 960.

Section 78 requires that any such inclusion be “grossed up” by the amount of the deemed paid FTC and that such indirect FTC is treated as a dividend.

Sourcing rules of foreign source income and limitation of foreign tax credits (FTCs)

U.S. persons are subject to worldwide taxation on income from all sources derived; and foreign persons are generally subject to U.S. tax only on their income from sources within the U.S. U.S. persons can offset their U.S. tax liability amount by FTCs. However, the FTCs that a U.S. person can use are generally limited to the U.S. tax imposed on the net foreign source income after apportionment and allocation of deductions.

Income is generally sourced in the geographic location from which that income is derived. There are a number of complicated rules that may apply when sourcing income, including the geographic location and the character of income. The Act changes some of the sourcing rules as described below. This article does not address the sourcing rules that have not been impacted by the Act.

Changes to inventory sourcing rules

There are two basic rules for determining the source of income from the sale of inventory property. The source of income from the sale of inventory1 depends on whether the inventory was (1) purchased for resale or (2) manufactured by the seller.

The regulations under section 863 indicate that income from the purchase and sale of inventory is sourced to the country where the sale takes place (i.e., where the contract is closed). As in effect prior to the Act, if the seller manufactured the property, then gross income was generally sourced under a 50/50 allocation method between the country of manufacture and the country of sale. The Act revises Section 863(b) to provide that gains, profits, and income derived from the sale or exchange of inventory property produced by the taxpayer in the U.S. will be sourced in the U.S. Conversely, income derived from the sale or exchange of inventory property produced by the taxpayer in a foreign country will be foreign-source income.  For a U.S. manufacturer or producer, the revised section 863(b) lowers the overall foreign-source income. The application of the provision will lower the amount of FTC that can be used to offset its total U.S. tax liability for the year.

Repeal of FMV of interest expense apportionment

The Act repeals the provision that allowed taxpayers to allocate interest expense using the fair market value of assets. Under section 864(e), all allocation and apportionment of interest expense shall be made on the basis of assets. Tax-exempt income, as well as the assets generating such income, are not taken into account for the purpose of interest expense allocation. The basis of an asset is the original cost of the asset less any depreciation, amortization or impairment costs made against such asset.

Section 904 limitations

The FTC calculation must be applied separately to each category of income, often referred to as income baskets. The foreign income and related taxes from one category cannot be combined with another category. This prevents averaging low-taxed income in one category with high-taxed income in another category which could overstate the FTC. Before the effective date of the Act (December 22, 2017), foreign tax credits limitations are applied separately with respect to two categories of income: general and passive income (“baskets”). Foreign taxes are subject to the overall foreign tax credit limitation rules of section 904(d) computed separately for the two baskets.

General category income is defined as income other than passive income. General category income generally includes wages, income earned in the active conduct of a trade or business, gains from the sale of inventory or depreciable property used in a trade or business, financial services income if it is derived by a financial services entity, high-taxed income that would otherwise be passive income, and all other income that does not fall into the passive category income. Passive category income generally includes: interest, dividends, rents, royalties, gains from sale or exchange, income inclusion from passive foreign investment companies (“PFICs”), and any other income not defined in another separate limit category. 

Separate basket for global intangible low-taxed income

The Code introduces a new type of income in section 951A: global intangible low-taxed income (”GILTI”). This new section requires U.S. shareholders (10% or more ownership requirement) of a CFC to include its pro-rata share of GILTI. GILTI is the excess of the shareholder’s “net CFC tested income” over the shareholder’s “net deemed tangible income return.” The CFC net tested income is the excess income over the losses from a CFC. GILTI does not include effectively connected income, subpart F income, foreign oil and gas income, or certain related party payments. The shareholder’s net deemed tangible income return is 10% of the qualified business asset investment (“QBAI”) of each CFC over the interest expense deducted in determining the net CFC tested income.\

Any amount of GILTI included in gross income will be included in a separate limitation basket. A domestic U.S. shareholder meeting the 10% ownership threshold will be allowed an 80% deemed paid foreign tax credit on the amount of foreign taxes paid by the foreign corporation attributable to the GILTI inclusion. The deemed paid foreign tax will offset the U.S. tax imposed on GILTI. The credit cannot be used to offset U.S. tax imposed on any other category of income. No carryover is allowed for excess credits.

GILTI – Credit Formulas

Deemed Paid Credit =  80% x GILTI                                  x    Aggregate Tested     
    Aggregate Tested Income      Foreign Income Tax 
Section 78 Gross Up = 100% x GILTI                                   x   Aggregate Tested     
    Aggregate Tested Income     Foreign Income Tax 

                       

Section 78 gross up includes 100% of the inclusion but only 80% credit of the foreign taxes imposed on the U.S. shareholder’s pro-rata share of the aggregate portion of its CFCs’ tested income included in GILTI will be available by application of section 960 to domestic corporate shareholders.

Example 1:

Domestic Corporation A owns 100% of company X, a CFC. The net tested income of the company X is $3,000 and the foreign income tax paid by the CFC is $450.

Foreign Tax Credit  Total
GILTI Inclusion  3,000
Tested Foreign Income Taxes  450
Section 960 Limitation for GILTI   80%
Deemed Paid FTC - Eligible   360

 

Taxable Income Impact  Total
Gross Income (GILTI) 3,000
Total Deduction =50% (GILTI + Section 78 Gross-up)  1,725
Taxable Income  1,275
Section 78 Gross Up  450
Tax Rate (Domestic C corporation) 21%
Pre-credit tax  362
Deemed Paid FTC  360
Net Tax Liability  2


Example 2:

U.S. individual shareholder A owns 100% of company X, a CFC. The net tested income of the company X is $3,000 and the foreign income tax paid by the CFC is $450.

Foreign Tax Credit  Total
GILTI Inclusion  3,000
Tested Foreign Income Taxes  450
Section 960 Limitation for GILTI  80%
 Deemed Paid FTC - Eligible   0

 

Taxable Income Impact  Total
Gross Income (GILTI) 3,000
Taxable Income  3,000
Individual Income Tax Rate – 37% 37%
Net Tax Liability  1,110

Separate basket for foreign branch income:

The Act adds a separate basket for foreign branch income under section 904(d)(1)(B). The term foreign branch income includes the business profits of a U.S. person attributable to a one or more qualified business units in one or more foreign countries. The foreign taxes imposed on the foreign branch profits will no longer offset the domestic parent’s non-branch related foreign source income.


1 A definition of inventory for this purpose is personal property held for sale to customers in the ordinary course of the seller’s business.

Shawn Carson is an International Tax Services Group Director experienced with international structuring, restructuring, financing and M&A work, as well structuring for U.S. companies investing overseas and foreign companies investing into the U.S.

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