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tured. This provision applies regardless of whether gain would otherwise be recognized.

Where gain would otherwise not be recognized, the taxpayer is treated under this provision as having received gain which is recognized in the year the taxpayer disposes of the property. (The gain to be recognized is limited to the amount of the foreign losses not yet recaptured.) In the case of a recapture resulting from the disposition of the property, 100 percent of the gain (to the extent of losses not previously recaptured) is recaptured. In such a case the 50-percent of gain limit is not applied, and the amount (if any) to be recaptured in future years is reduced by the full amount of the gain.

The application of the foreign loss recapture rule of current law is illustrated in Example B (below). The taxpayer in Example B is Taxpayer 1 of Example A. For simplicity, Example B assumes that Taxpayer 1 chooses to have 100 percent of the foreign income recharacterized as domestic income in the year in which recharacterization takes place.

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1 Foreign tax credit limitation: Foreign source income (zero, since it has been recharacterized as U.S. income)/worldwide taxable income ($200) multiplied by U.S. tax ($92) equals 0.

Under the foreign loss recapture rule, Taxpayer 1 pays $92 of U.S. tax on U.S.-source taxable income of $200 for the 2-year period. A comparison of Examples A and B shows that this is the same amount of U.S. tax paid by Taxpayer 2 in Example A, who also had U.S.-source taxable income of $200 for the two-year period, but no foreign losses. In addition, $92 of U.S. tax is the amount normally due on $200 of U.S.-source taxable income, assuming a 46percent average U.S. tax rate.

Foreign tax credit carryovers

Under present law, excess foreign tax credits (i.e., foreign taxes which, because of the foreign tax credit limitation, cannot be cred

ited in the year paid or accrued) generally may be carried back for 2 years and carried forward for five years (sec. 904(c)).

The Congress enacted the foreign tax credit carryback and carryover in 1958 to eliminate the double taxation which sometimes resulted under prior law when a method of reporting income in a foreign country differed from the method in the United States. This may result in reporting the same income in one year in the United States and in another year in the foreign country. When this occurs, the foreign tax credit currently available under the foreign tax credit limitation tends to be less than the taxes paid or accrued to the foreign country in the year the income is reported in that country but not in the United States. In another year when this income is reported in the United States but not the foreign country, the credit which will be available currently under the limitation tends to exceed the foreign taxes paid or accrued. 5

Section 904(c) permits foreign taxes which cannot be claimed currently as a tax credit to be carried back successively to the second and first preceding taxable years and then forward to the first, second, third, fourth, and fifth succeeding taxable years. The credits so carried are deemed paid or accrued in the earlier or later years and may be used in such years to the extent that creditable foreign taxes actually paid or accrued for such years do not equal or exceed the applicable foreign tax credit limitation amounts. Under this rule, current foreign taxes are credited against U.S. tax before foreign taxes carried from other years are credited against U.S. tax.

In contrast with foreign tax credits, investment tax credits generally may be carried forward for 3 years and carried over for 15 years (sec. 46(b)). In addition, investment tax credits are utilized in accordance with a first-in first-out (FIFO) ordering rule. Under this rule, investment credit carryovers are used before current investment credits (sec. 46(a)(1)).

In any taxable year, foreign tax credits (including carrybacks and carryovers) are used before all other types of income tax credits, excluding the credit for the elderly. However, net operating loss carrybacks and carryovers generally reduce income, and hence U.S. tax, before foreign tax and other credits are used.

5 The report of the House Committee on Ways and Means on the legislation creating the foreign tax credit carryback and carryover listed factors which may result in a difference in the timing of reporting of income and allowance of deductions: "(1) Reporting of taxable income from sales on the installment basis in the United States without being permitted to report in a similar manner in a foreign country (or possession of the United States); (2) Differences under the laws of the United States and those of the foreign country in the pricing of inventories (this may result in the reporting of income from the ultimate sale of such articles in a different year in the United States than in the foreign country); (3) Differences in reporting foreign exchange profit or loss (such profit or loss may be reported on the accrual basis in the United States but only on the cash basis in some foreign countries); (4) Differences in depreciation methods in the United States and in the foreign country; (5) The requirement of some countries that income taxes be determined only on a fiscal-year basis; and (6) The use of an averaging device in the computation of taxable income in certain foreign countries covering more than one taxable year. See H.R. Rep. No. 775, 85th Cong., 1st Sess. 27-28 (1957).

Explanation of the Bill

a. Domestic loss recapture rule

In general

The bill would establish a domestic loss recapture rule the operation of which would be similar to the operation of the present foreign loss recapture rule (Code sec. 904(f)).

The recapture of domestic losses would be accomplished under the bill by treating as income from foreign sources a portion of domestic income which is derived after a year in which an overall domestic loss is incurred. The portion of domestic income treated as income from foreign sources would represent the overall domestic loss which, in the previous year, had the effect of reducing precredit U.S. tax and, consequently, the potentially utilizable amount of foreign tax credits in that year. The effect of the recharacterization would be to increase the foreign tax credit limitation and, thus, potentially, the amount of utilizable foreign tax credits, in the later year or years.

Amount subject to recapture

The amount of domestic income treated as foreign-source income in a subsequent year would be limited under the bill to the lesser of the amount of the overall domestic loss (to the extent that the loss has not been recaptured in prior taxable years) or 50 percent of the domestic taxable income for that year, or such larger percentage as the taxpayer may choose. Thus, in any taxable year the amount subject to recapture would not exceed 50 percent of the taxpayer's domestic income (before recharacterization), unless the taxpayer chose to have a greater percentage of domestic income so recharacterized.

Definition of overall domestic loss

For purposes of the domestic loss recapture rule, the bill would define the term overall domestic loss to mean the amount by which the taxpayer's gross income from sources within the United States (including the amount, if any, that is treated as income from sources within the United States under the foreign loss recapture rule) is exceeded by the sum of the deductions properly apportioned or allocated to domestic sources, to the extent such loss amount offsets income from foreign sources.

In computing the amount of the overall domestic loss, casualty or theft losses would not be taken into account. The definition of overall domestic loss contained in the bill, unlike the present-law definition of overall foreign loss (Code sec. 904(f)(2)), would not expressly provide that the net operating loss deduction (sec. 172(a)) is not to be taken into account in computing the overall loss. Under the bill, a taxpayer would be treated as sustaining a domestic loss whether or not claiming a foreign tax credit for the year of the loss.

Amendments to foreign loss recapture rule

The bill would amend the foreign loss recapture rule in a minor respect. It would modify the definition of overall foreign loss for

foreign loss recapture rule purposes so that domestic income recharacterized as foreign income under the domestic loss recapture rule would be counted in the computation of overall foreign loss.

Example

Example C (below) shows how, under present law, two taxpayers with the same total taxable worldwide income and foreign taxes over a two-year period, one of whom has domestic losses in one year and one of whom does not, may pay different amounts of U.S. tax and may use different amounts of foreign tax credits over the two-year period.

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1 Foreign tax credit limitation: Foreign source income ($100)/worldwide taxable income ($200) multiplied by U.S. tax ($92) equals $46.

2 Foreign tax credit limitation: Foreign source income ($100)/worldwide taxable income ($100) multiplied by U.S. tax ($46) equals $46.

In Example C, each taxpayer has a total two-year worldwide taxable income of $200. Each has no U.S.-source taxable income for the two-year period. The taxpayer with an overall domestic loss (Taxpayer 3) pays $46 in U.S. tax and $92 in foreign tax for the two-year period and accrues $46 of excess foreign tax credits. Taxpayer 4, the taxpayer with no domestic loss, pays no U.S. tax and

$92 in foreign tax for the two-year period and accrues no excess foreign tax credits.

Enactment of the domestic loss recapture rule would have the effect on Taxpayer 3 illustrated in Example D below. Example D assumes that Taxpayer 3 chooses to have 100 percent of U.S.-source income recharacterized as foreign income in Year 2.

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1 Foreign tax credit limitation: Foreign source income ($200, since the domestic income in Year 2 is recharacterized as foreign income)/worldwide taxable income ($200) multiplied by $92 equals $92.

Under the domestic loss recapture rule, Taxpayer 3 would pay no U.S. tax and accrue no excess foreign tax credits for the two-year period. A comparison of Examples C and D shows that this is the same U.S. tax and excess foreign tax credit position as that of a taxpayer who does not have domestic losses (Taxpayer 4).

Effective date

The domestic loss recapture rule and related amendments would apply to taxable years beginning after 1981.

b. Extended carryover period for certain excess foreign tax credits The bill would increase the foreign tax credit carryover period from five years to 15 years for excess foreign tax credits that arise · in taxable years beginning after 1978.

c. FIFO ordering rule for foreign tax credits

In general

The bill would provide a new first-in first-out (FIFO) ordering rule for utilization of foreign tax credits. Under this rule, foreign tax credits that arise currently in the taxable year would no longer be the first foreign tax credits utilized in the taxable year; instead, foreign tax credits would generally be utilized in the order in which they arose. Thus, in any taxable year, foreign tax credit carryovers would be utilized first.

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