Page images
PDF
EPUB

TITLE XII—FOREIGN TAX PROVISIONS

A. Foreign Tax Credit (Secs. 1201 through 1205 of the Act and secs. 864, 901, 902, 904, 954, 960, and 6038 of the Code)1

In general

Prior Law

The United States taxes U.S. persons on their worldwide income, including their foreign income. Congress enacted the foreign tax credit in 1918 to prevent U.S. taxpayers from being taxed twice on their foreign income-once by the foreign country where the income is earned, and again by the United States. The foreign tax credit generally allows U.S. taxpayers to reduce the U.S. tax on their foreign income by the foreign income taxes they pay on that income.

The United States allows a foreign tax credit for foreign taxes paid on income derived from direct operations (conducted, for example, through a branch office) or passive investments in a foreign country. The United States also allows a credit with respect to dividends received from foreign subsidiary corporations out of earnings that have been subject to foreign taxes. The latter credit, which is discussed in more detail below, is called a deemed-paid credit or an indirect credit.

Creditability rules and withholding taxes on interest

The foreign tax credit is available only for income, war profits, and excess profits taxes paid to a foreign country or a U.S. possession and for certain taxes imposed in lieu of them (Code secs. 901 and 903). Other foreign levies generally are treated as deductible expenses only. To be creditable, a foreign levy must be the substantial equivalent of an income tax in the U.S. sense, whatever the foreign government that imposes it may call it.2 To be considered an income tax, a foreign levy must be directed at the taxpayer's net gain.3

Treasury regulations promulgated under Code sections 901 and 903 provide detailed rules for determining whether a foreign levy is creditable (Treas. Reg. secs. 1.901-1 through 1.901-4 and 1.903-1). In general, a foreign levy is creditable only if the levy is a tax and its predominant character is that of an income tax in the U.S. sense. A levy is a tax if it is a compulsory payment under the authority of a foreign country to levy taxes and is not compensation for a spe

1 For legislative background of the provisions, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, secs. 601-04; H.Rep. 99-426, pp. 329-58; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, secs. 901-05; S.Rep. 99313, pp. 293-327; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 561-94 (Conference Report). 2 Biddle v. Commissioner, 302 U.S. 573 (1938).

3 Bank of America National T. & S. Association v. United States, 459 F.2d 513 (Ct. Cl. 1972).

cific economic benefit provided by a foreign country such as the right to extract petroleum owned by the foreign country. The predominant character of a levy is that of an income tax in the U.S. sense if the levy is likely to reach net gain in the normal circumstances in which it applies and the levy is not conditioned on the availability of a foreign tax credit in another country (a levy that is so conditioned is referred to as a "soak-up" tax).

Taxpayers who are subject to a foreign levy and also receive a specific economic benefit from the levying country are referred to as dual capacity taxpayers under the regulations. Dual capacity taxpayers may obtain a credit only for that portion of the foreign levy that they can establish was not compensation for the specific economic benefit received. A specific economic benefit is any economic benefit that is not made available on substantially the same terms to substantially all persons who are subject to the income tax that is generally imposed by the levying country, or, if there is no such generally imposed income tax, any economic benefit that is not made available on substantially the same terms to the population of the country in general. An economic benefit includes property; a service; a fee or other payment; a right to use, acquire or extract resources, patents or other property that a foreign country owns or controls; or a reduction or discharge of a contractual obligation. It does not include the right or privilege merely to engage in business generally or to engage in business in a particular form. A foreign levy is a creditable tax "in lieu of" an income tax under the regulations only if the levy is a tax and is a substitute for, rather than an addition to, a generally imposed income tax. A foreign levy may satisfy the substitution requirement only to the extent that it is not a soak-up tax.

The regulations generally test the creditability of gross withholding taxes on interest under the "in lieu of" creditability rules of section 903 rather than under the general creditability rules of section 901. Such withholding taxes generally were tested for creditability under section 901 under prior regulations.

An earlier version of the regulation governing "in lieu of" taxes (Temp. Treas. Reg. sec. 4.903-1, T.D. 7739, filed November 12, 1980) required that a foreign levy be comparable in amount to the amount that would have been paid on the income involved had the general income tax of the levying country (or U.S. possession) applied to that income. The Treasury Department omitted the comparability rule from the final regulations after concluding that the statutory language of section 903 probably did not grant the IRS sufficient authority to promulgate such a rule.

The foreign tax credit for taxes on foreign oil related income, by contrast, is limited by a comparability rule (Code sec. 907(b)). Under this comparability rule, a foreign tax on oil related income is noncreditable to the extent that the Secretary determines that the foreign law imposing the tax is structured, or in fact operates, so that the amount of tax imposed with respect to foreign oil related income will generally be materially greater, over a reasonable period of time, than the amount generally imposed on income that is neither foreign oil related income nor foreign oil and gas extraction income.

Treasury regulations allow a credit only for that amount of an income tax or "in lieu of" tax that is paid to a foreign country by the taxpayer. The Treasury regulations provide that the "taxpayer" is the person upon whom foreign law imposes legal liability for a tax. However, a tax is considered paid by the taxpayer even if another party to a transaction with the taxpayer agrees, as a part of the transaction, to assume the taxpayer's liability for the tax (Treas. Reg. sec. 1.901-2(f)(2)(i)). Foreign borrowers frequently pay interest on loans from U.S. lenders "net" of income taxes. That is, the borrowers promise the lenders a certain after-foreign tax interest rate on the loans and agree to assume the lenders' liability for any foreign taxes imposed. The borrower may pay the taxes directly, pay additional interest to the lender equal to the tax the lender must pay, or reimburse the lender directly for the tax the lender pays. Foreign taxes paid by foreign borrowers pursuant to such arrangements are income to the U.S. lenders, and, in general, under the regulations, are creditable in full by the U.S. lenders: the taxes are considered paid by the lenders notwithstanding that the foreign borrowers agree to pay them, provided that the levying country does not refund or otherwise forgive the taxes. However, in certain cases where the foreign borrower is a foreign government or is owned by a foreign government, prior and present law may be unclear regarding whether foreign taxes are creditable in full by the U.S. lender.

Under the Treasury regulations on creditability, a tax is not "paid" to a foreign country to the extent that it is reasonably certain to be refunded, credited, rebated, abated, or forgiven (Treas. Reg. sec. 1.901-2(e)(2)). To encourage foreign lenders to lend to their residents, some countries have attempted to subsidize foreign loans to their residents by rebating to their residents, directly or indirectly, all or a portion of the withholding taxes that the countries impose on the interest paid on loans from foreign lenders. Since the taxes are not formally rebated to the lenders, some U.S. lenders argue that they have "paid" the taxes and, therefore, should be granted foreign tax credits for them. The regulations disallow foreign tax credits in these cases, however. Under the regulations, a tax is not "paid" to a foreign country if it is used directly or indirectly as a subsidy to the taxpayer or certain persons who are related to the taxpayer or engaged in transactions with the taxpayer (Treas. Reg. sec. 1.901-2(e)(3)).

Foreign tax credit limitation

A premise of the foreign tax credit is that it should not reduce a taxpayer's U.S. tax on its U.S. income, only a taxpayer's U.S. tax on its foreign income. Permitting the foreign tax credit to reduce U.S. tax on U.S. income would in effect cede to foreign countries the primary right to tax income earned in the United States.

The tax law imposes a limitation (first enacted in 1921) on the amount of foreign tax credits that can be claimed in a year that prevents a taxpayer from using foreign tax credits to offset U.S. tax on U.S. income. This limitation generally is calculated by prorating a taxpayer's pre-credit U.S. tax on its worldwide taxable income (U.S. and foreign taxable income combined) between its U.S. and foreign taxable income. The ratio of the taxpayer's foreign

taxable income to its worldwide taxable income is multiplied by the taxpayer's total pre-credit U.S. tax to establish the amount of U.S. tax allocable to the taxpayer's foreign income and, thus, the upper limit on the foreign tax credit for the year.

Overall and per country limitations

Historically, the foreign tax credit limitation has been determined on the basis of total foreign income (an "overall" limitation or method), foreign income earned in a particular country (a “per country" limitation or method), or both.

Under an overall method, the taxpayer adds up its net income and net losses from all sources outside the United States and allocates its pre-credit U.S. tax based on the total. An overall method permits "averaging" for limitation purposes of the income and losses generated in, and the taxes paid to, the various foreign countries in which a taxpayer operates and other income and losses sourced outside the United States. An overall method also permits averaging of tax rates applied to different types of income.

Under a per country method, the taxpayer calculates the foreign tax credit limitation separately for each country in which it earns income. The foreign income taken into account in each calculation is the foreign income derived from the foreign country for which the limitation is being determined. Thus, a per country limitation prevents the use of taxes imposed by one country to reduce U.S. tax on income arising elsewhere. Otherwise, a per country limitation is calculated in basically the same manner as an overall limitation.

From 1921 until 1932, an overall limitation was in effect. Between 1932 and 1954, foreign tax credits were limited to the lesser of the overall or per country limitation amount. In 1954, Congress amended the law to allow only a per country limitation. From 1960 to 1975, Congress permitted taxpayers to elect between an overall and a per country method. Since 1976, an overall limitation has been mandatory.

The per country limitation rules of prior law permitted a taxpayer first to use the entire amount of a net loss incurred in any foreign country to reduce its U.S. taxable income. The taxpayer received a second tax benefit when in a later year, it earned income in the loss country and that country imposed tax on the income at a rate higher than the U.S. rate and had no net operating loss carryforward provision. A full foreign tax credit was allowed for that tax, eliminating the U.S. tax on the income, even though the earlier loss had reduced U.S. taxable income and, thus, U.S. tax, also. Congress repealed the per country limitation and enacted the overall foreign loss recapture rule (discussed below under "Foreign losses" in 1976 to eliminate this double tax benefit.

Separate limitations

Under present and prior law, the overall foreign tax credit limitation is calculated separately for DISC dividends, FSC dividends, and taxable income of a FSC attributable to foreign trade income (sec. 904(d)). Also, a special limitation applies to the credit for taxes imposed on oil and gas extraction income (sec. 907(a)). Under prior

law, the overall foreign tax credit limitation was also calculated separately for passive interest income.

In general, prior law's separate limitation for passive interest income applied to any interest other than the following: interest derived from any transaction which was directly related to the active conduct of a trade or business in a foreign country or a U.S. possession; interest derived in the conduct of a banking, financing, or similar business; or interest received on obligations acquired as a result of the disposition of a trade or business actively conducted in a foreign country or U.S. possession or as a result of the disposition of stock or obligations of a corporation in which the taxpayer owned at least 10 percent of the voting stock.

The separate limitation for passive interest generally did not apply to interest received from a corporation in which the taxpayer (or one or more includible corporations in an affiliated group of which the taxpayer was a member) owned, directly or indirectly, at least 10 percent of the voting stock. However, under the Tax Reform Act of 1984, the separate limitation did apply to subpart F and foreign personal holding company inclusions of, and dividends and interest received by, a U.S. person that were attributable to separate limitation interest income of a 10-percent U.S.-owned foreign corporation or a regulated investment company.

Under the special limitation for oil and gas extraction income, otherwise creditable amounts claimed as taxes paid on foreign oil and gas extraction income of a U.S. company may be credited only to the extent that they do not exceed the highest U.S. corporate tax rate multiplied by the amount of such extraction income. Payments in excess of this limitation generally may be carried back and forward and credited against the U.S. tax otherwise due on extraction income earned in the carryback and carryforward years. A separate or special limitation generally is applied to a category of income for one of three reasons: the income's source (foreign or U.S.) can be manipulated; the income typically bears little or no foreign tax; or the income often bears a rate of foreign tax that is abnormally high or in excess of rates on other types of income. Applying a separate limitation to a category of income prevents the use of foreign taxes imposed on one category of income to reduce the U.S. tax on other categories of income.

For example, under the separate limitation for passive interest, high foreign taxes paid on manufacturing income generally did not reduce the U.S. tax on interest income that was lightly taxed abroad. Similarly, under the special limitation for oil and gas extraction income, foreign levies on oil and gas extraction income of a corporation, to the extent that they exceed the highest U.S. tax that can apply to such income, cannot reduce the U.S. tax on lightly taxed, nonextraction income. Separate limitations help to preserve the U.S. tax on foreign income that frequently bears little or no foreign tax while at the same time ensuring that double taxation is relieved with respect to all categories of income.

Under prior law, some categories of foreign income, such as passive income, that are relatively manipulable with respect to source and that tend to be lightly taxed abroad were not generally subject to separate limitations. Passive interest income, as already indicat ed, was subject to a separate limitation. An example of passive

« PreviousContinue »