New Guidance on Foreign Tax Credits (FTC)
The landmark Tax Cuts and Jobs Act (TCJA), passed in late 2017, modified the foreign tax credit (FTC) rules, which allow U.S. taxpayers to offset their taxes by the amount of foreign income taxes they have paid or accrued. Then in November 2018, the IRS released extensive proposed regulations (REG-105600-18) to implement changes to the FTC regime brought about by the TCJA.
The regulations provided much-needed clarity in some areas. That said, they add a level of complexity to determining FTC that will be a burden for taxpayers. The Treasury itself has recognized the complexity of the new rules and has requested comments about whether certain calculations should be simplified. I think it’s safe to anticipate more changes on the horizon, but let’s get you caught up to date.
Overview of FTC
The United States uses a "worldwide" tax system. That means the U.S. imposes a tax on the worldwide income of U.S. corporations, as well as on the worldwide income of its citizens, residents, and domestic trusts. By contrast, many nations impose a "territorial" system of taxation which means they only tax income generated from sources within their country’s borders.
EXAMPLE: Let’s say Dave, a U.S. citizen, is living and working in China. Dave earns income in China from his job and also has a bank account in China that is generating interest income. Because Dave is a U.S. citizen, the U.S. requires Dave to file a U.S. income tax return that reports his income earned in China. The U.S. also requires Dave to pay the IRS tax on his income earned in China. The problem for Dave is that China also wants Dave to file a Chinese income tax return, to report his income earned in China, and to pay tax on that same income.
To alleviate that problem, the U.S. gives taxpayers like Dave an FTC against their U.S. tax liability for taxes imposed by foreign countries. This FTC is designed to ensure that U.S. taxpayers are not subject to double taxation and are therefore not discouraged from earning income overseas.
The FTC allowed by the U.S. is limited to the U.S. tax imposed on foreign sourced income. The idea behind the limitation is to ensure that the taxpayer’s FTC is not used to offset their tax liability on income earned within the U.S.
It’s important to note that the FTC limitation is calculated separately for each category or "basket" of income. For pre-2018 tax years, there were two primary categories:
- The general income category, and
- The passive income category.
Using our example of Dave (above), here are the steps he would have to take to determine his FTC:
- Action Item: Determine foreign sourced general category income.
- Notes: Includes income that Dave earns from performing services in China.
- Action Item: Determine foreign income tax imposed on general category income.
- Notes: Includes the Chinese tax imposed on Dave's income earned in China.
- Action Items: Determine the U.S. tax liability on foreign sourced general category income.
- Notes: This would be the portion of Dave's U.S. income tax liability attributable to that income. Dave would calculate this on Form 1116.
- Action Items: Calculate the allowable FTC on foreign sourced general category income.
- Notes: The allowable credit is equal to the lesser of the amount that Dave determined under either Step 2 or Step 3.
Dave would repeat those same three steps above for the interest income earned in his Chinese bank account (i.e., passive category income). Dave would then combine the total of the allowable FTC for the general and passive categories of income, then use that amount to offset his U.S. tax liability on that same income. If there are any Chinese income taxes imposed that are more than the allowable credit, Dave could then carry those taxes (in their separate baskets) back by one year and/or forward by ten years.
Changes to FTC since passage of tax reform
The TCJA bought about significant changes to the FTC rules. To get a sense of how significant these changes have been, you could look to the 312 pages of proposed FTC regulations that the Treasury published in November 2018. The highlight of the changes has been the introduction of two new limitations or categories of income:
1. The Foreign branch income category and
2. The Global Intangible Low-Taxed Income (GILTI) category.
Foreign branch income includes business income that is derived through a foreign branch of a U.S. business entity. A foreign branch is a qualified business unit (QBU) that conducts a trade or business outside of the U.S. To identify foreign branches, taxpayers should look at activities outside of the U.S. that they are either conducting directly through disregarded entities, partnerships, or similar tax transparent entities. Taxpayers should also be aware of the other TCJA changes, in which the IRS has expanded Form 8858 reporting for the 2018 tax year to include foreign branches. Form 8858 reporting previously only applied to foreign disregarded entities.
GILTI includes 951A inclusions that are not passive category income. (For more information about GILTI see my recent article New Guidance on Global Intangible Low-Taxed Income). A unique aspect of the GILTI FTC limitation is that the limitation is determined on year by year basis. There are no carryforwards or carrybacks allowed for the GILTI FTC. Taxpayers should be aware of these constraints and plan accordingly.
Real world example
To see how these new categories of income may affect U.S. taxpayers, let’s say there is a U.S. company called ABC Technology Company (“ABC”). ABC has a subsidiary in the United Kingdom that targets the European market. ABC licenses some of its technology to the U.K. subsidiary which generates a royalty. ABC has invested in a manufacturing joint venture in China that is treated as a partnership for U.S. tax purposes. What’s more, ABC has made a loan to a promising startup headquartered in the Cayman Islands and ABC is considering taking an equity stake in that startup.
When filing its U.S. return, ABC would be required to determine its allowable FTC using the same 4-step process for 4 different categories of income that we used for our overseas worker Dave in the example above. Those four categories include:
1. The GILTI category (on GILTI from the U.K. subsidiary).
2. The general category (from the royalty from the U.K. subsidiary).
3. The foreign branch income category (on partnership income from the Chinese manufacturing joint venture), and
4. The passive category (on interest income from the loan to the Cayman company).
If ABC had an excess FTC limitation in one category, then it would not be able to use that excess to offset foreign sourced income from another category. So, the introduction of two additional FTC limitations may minimize the amount of FTCs that U.S. persons can claim.
Strategies for taxing advantage of the new FTC rules
The first thing that taxpayers need to look at this year is how they want to report any pre-2018 FTC carryforwards they may have accrued. The default rule is that general and passive category FTC are carried forward to post-2017 years in those same baskets. However, there is a one-time optional reallocation of general basket FTC’s to the foreign branch income basket.
The reallocation applies to FTC carryovers to the extent that those carryovers would have been allocated to the foreign branch basket under the new rules. The reallocation must also apply to all of the unused FTC carryovers – thus, a company is not allowed to pick and choose which FTC it reallocates. To determine whether a reallocation makes sense, a company should analyze its future income streams and the taxes allocable to those income streams.
The other thing that U.S. taxpayers need to look at is their GILTI FTC position. The GILTI basket has no carryforwards or carrybacks. This could be an issue for taxpayers that use the "paid" method to determine their FTC's.
For background, the paid method takes an FTC on a cash basis in the year that foreign taxes are actually paid. Taxpayers using the paid method will, therefore, need to time their foreign income tax payments to avoid having a year with a GILTI FTC excess limitation and then another year with a GILTI liability. The alternative would be switching to an "accrued" method. Taxpayers on the accrued method take an FTC in the year that the taxes accrue so their FTC is already aligned with the income that it relates to.
New guidance on the horizon
The Treasury has addressed most of the relevant issues in the 312 pages of regulations. That said, there are a few technical items for which the Treasury mentioned would be open to comments in the Federal Register Volume 83 published in December 2018. Here are some of the technical points that the Treasury mentioned:
- Whether additional rules should be issued to account for gross tested income earned in lower tier Controlled Foreign Corporations (CFC's) including those that produce tested losses.
- Whether the expense apportionment rules need to be further revised to take into account the GILTI category of income.
- Whether there should be a simplified method for taxpayers to determine which FTC carryforwards should go to the foreign branch income basket when they choose to reallocate their carryforwards.
- Whether additional changes are needed to the high tax income rules given the two new categories of income added by the TCJA.
- Whether changes to the gross income-based test for determining financial services entity status are appropriate.
The changes brought about by the TCJA represent the biggest change to FTCs since 2007 when the number of categories shrunk to two from nine. The technical nature of the underlying rules will make this upcoming year challenging for taxpayers and their professional advisors. It is critical that taxpayers get the reporting right in this first year. If you or a colleague has questions about the impact of FTC or GILTI on your business or investment, please don’t hesitate to contact me at 714.361.7685 or John.Samtoy@hcvt.com
John Samtoy is a Tax Principal in the Irvine, CA office of HCVT. John specializes in international tax consulting and compliance services and serves high net worth individuals, closely held businesses, and private equity clients across a variety of industries. John has experience serving multinational clients immigrating to and doing business in the U.S. as well as U.S. clients working and establishing operations overseas.