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Foreign Tax Credits for Individuals: Form 1116 Changes, Final and Proposed RegulationsTHURSDAY, DECEMBER 10, 2020, 1:00-2:50 pm Eastern

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December 10, 2020

Foreign Tax Credits for Individuals: Form 1116 Changes, Final and Proposed Regulations

Alison N. Dougherty, J.D., LL.M., CPA

Director, Tax Services

Aronson LLC

[email protected]

John Samtoy

Tax Partner

Holthouse Carlin & Van Trigt LLP

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

FOCUS • CLARITY • COMMITMENT

FOREIGN TAX CREDITS FOR INDIVIDUALS

December 10, 2020John Samtoy, HCVT [email protected]

T A X | A U D I T | B U S I N E S S M A N A G E M E N T | M E R G E R S & A C Q U I S I T I O N S

TOPICS COVERED

• Overview and Background

• Foreign Taxes Eligible for Credit

• §962 Election and the High Tax Exception

• Foreign Tax Credit Limitation

• Foreign Branch Income

• GILTI Income

• Income Re-sourced by Treaty

• Allocation of Expenses

6


OVERVIEW AND BACKGROUND

• Foreign Tax Credit Overview

• U.S. persons are subject to tax on worldwide income.

• A credit against the U.S. tax liability is allowed for taxes imposed by foreign countries.

• Credit is limited to the U.S. tax that applies to foreign sourced income.

• Limitation is calculated separately for each category or “basket” of income.

7


FOREIGN TAXES ELIGIBLE FOR CREDIT

• Foreign taxes eligible for credit

• Income tax (a tax imposed on income) or a tax in lieu of an income tax and

• Imposed by a foreign country or U.S. possession

• Tax – “compulsory payment pursuant to the authority of a foreign country to levy taxes”

• Compulsory payment – amount taxpayer is liable for after applying foreign tax law (including application of tax treaties).

• No specific economic benefit – taxpayer cannot receive an economic benefit that is not “available on substantially the same terms to substantially all persons”

• Pursuant to authority to levy taxes – imposed by foreign government in its role as a ‘revenue raiser’ and not as a regulator or property owner.

• Example: hunting or fishing license, automobile registration fees, penalties –role as regulator.

8



• Income Tax - must satisfy three tests: realization, gross receipts, net income

• Realization –tax imposed on income that is realized under U.S. tax principles. Exception where there is no subsequent tax and tax is imposed on:

• Pre-realization event: • To recapture a tax benefit, or, • Imposed on difference in property values at the beginning and

end of a taxable period, or,• A physical transfer, change in, or export of readily marketable

property (inventory),• Deemed distribution of profits (to shareholders of a corporation).

9



• Gross Receipts – tax base must be imposed on gross receipts or a computed amount that is not likely to exceed actual gross receipts.

• Example (creditable): headquarters tax imposed by a country where the gross receipts on a headquarters company is deemed to equal 110% of expenses.

• Example (not creditable): tax imposed on presumed rental value of a residence.

• Net Income – tax is on income after the recovery of significant costs and expenses attributable to income or under a method that approximates those expenses.

• Attributable expenses and recovery of investment costs (depreciation and amortization).

• Capitalization rules/other rules do not need to follow U.S. law.

1 0



• Taxes in lieu of an income tax• Country must have a generally imposed income tax

• Taxpayer would have been subject to income tax but a specific provision imposes the in lieu of tax instead as a substitute tax.

• Income tax is not also imposed on the taxpayer subject to in lieu of tax on the same income.

• Example: Taxpayer subject to gross receipts tax on insurance activity and income tax on other activities is ok.

• In lieu of tax is a ‘tax’ under the 901 definitions (covered earlier)

• Is not a ‘soak-up’ tax1 1



• Soak-up tax rule – applies to all foreign taxes

• Taxes that are imposed only on or at a higher rate on residents of a country that allows a tax credit for those taxes.

• Not creditable to the extent they are at a higher rate than taxes imposed on taxpayers that are not eligible for a tax credit.

• Imposed by a foreign country or possession

• Foreign country and any political subdivision of a foreign state (ex – state / province level income taxes in a foreign country).

1 2



• Income tax treaties and country specific rulings• “Typically” clarify treatment of specific taxes but do not expand the

definition of foreign taxes allowable for credit.

• See ‘taxes covered’ article with language to include ‘substantially similar’ taxes.

• Still need to be aware of rules that are applicable on a country by country basis.

• Example: Netherlands tax on imputed investment income (net worth of savings and investments) is allowable as a foreign tax credit –Revenue Ruling 2002-16

• Without ruling would not satisfy realization, gross receipts, net income tests.

1 3


EXAMPLE: FOREIGN INCOME TAXES

1 4

• A foreign tax is imposed at the rate of 40 percent on wages realized by an employee;

• No deductions are allowed on wages.• Costs and expenses of employees viewed

as typically insignificant compared to income.

• Tax satisfies the net income requirement.• Restriction on employees being able to

deduct costs is not ‘significant’ and therefore does not disqualify the tax as an income tax.

Example from Reg 1.902-1

Taxpayer

Country X

Tax at 40% on income earned as an employee with no deduction - qualifies


EXAMPLE: SOAK UP TAXES

1 5

• A withholding tax of 30% is imposed on dividends from Uruguay Co paid to nonresidents only if the recipient’s country allows a tax credit for the withholding tax.

• The withholding tax (on dividends) would otherwise be creditable to Taxpayer however they are only imposed on residents of certain countries that allow a tax credit.

• They are therefore considered a “soak-up” tax. • The withholding tax is therefore not a

creditable tax.

Example from Revenue Ruling 87-39

Taxpayer

Uruguay Co.

Withholding tax on dividend applies only if non-resident taxpayer receives a tax credit for Uruguay withholding taxes.

Dividend


EXAMPLE: IN LIEU OF TAX

1 6

• Country X has a tax on realized net income that is generally imposed. Nonresidents are subject to a separate gross income tax on income from country X that is not attributable to a trade or business carried on in country X.

• Tax qualifies as an ‘in lieu’ of tax whether it is paid by the nonresident directly or through withholding.

• Country X imposes both an excise tax and an income tax. The excise tax, which is payable independently of the income tax, is allowed as a credit against the income tax. The excise tax paid is imposed in addition to, and not in substitution for, the generally imposed income tax.

• Even though a credit is allowed the taxpayer is subject to an income tax and a separate excise tax on the same income. No credit is allowed under 903.

Examples from Reg 1.903-1

Taxpayer

Country X



• Individual taxpayers are generally limited to claiming a foreign tax credit on ‘direct’ foreign taxes.

• Direct - taxpayer is liable for foreign tax or is the owner of the income on which the foreign taxes are imposed under U.S. tax purposes.

• Includes taxes paid by flow through (‘transparent’) entities

• Withholding taxes are considered direct taxes of the payee of the income even though they are imposed on the payor.

• Indirect taxes – income taxes imposed on a foreign corporate entity.

• U.S. Corporations may claim indirect credits (on deemed income only after tax reform – 902 is repealed).

• Where there is deemed income (951) consider the impact of the 962 election and the high tax exception.

• Consider the impact of the check-the-box election

1 7


EXAMPLE: DIRECT / INDIRECT TAXES AND ELECTIONS

1 8

Indv(U.S.)

Germany

German corporate entity – no foreign tax credit allowed for

indirect taxes

Germany

Indv(U.S.)

Dividend

German entity treated as transparent for U.S. tax purposes per a check-the-box election – credit

allowed

$100 income 30% Germany tax

$100 of U.S. income at 37% rate = $37 tax liability

$30 FTC = $7 due in U.S. after FTC

ETR = 37% (30+7)

$100 income 30% Germany tax = $70 E&P

$70 dividend income 20% tax on dividends = $14 U.S. tax

ETR = 44% (30+14)


§951 INCOME AND THE 962 ELECTION

1 9

Indv(U.S.)

Germany

German corporate entity – no foreign tax credit allowed for

indirect taxes

100% of earnings are GILTI

§962 election to be taxed at the corporate rates under §11 on all §951(a) income from all CFCs in

which the taxpayer is a U.S. shareholder.

• At a high level the §962 election imposes tax ‘as if’ a domestic corporation received all §951(a) income only.

• Domestic corporations are eligible for an indirect tax credit under §960 on taxes paid with respect to §951 inclusions. A gross up for taxes paid is required.

• When an actual distribution is made from income previously taxed under a §962 election the distribution, less any U.S. taxes actually paid under the election, will be subject to tax again.

• In this case that would take us back to the ETR of 44% shown in the first scenario.

$100 income 30% Germany tax = $70 E&P

$70 GILTI inclusion and 37% tax on ordinary income = $25.9 U.S. tax

ETR = 55.9% (30+25.9)

Indiv (U.S.)

Germany

100%

962 –theoretical domestic

corporation


§951 INCOME AND THE 962 ELECTION

2 0

$100 income * 30% German tax = $70 E&P

• §962 election – no liability in this case because of tax credits under §960

• $70 dividend income 20% tax on dividends = $14 U.S. tax

• ETR = 44% (30+14)

Indiv (U.S.)

Germany

100%

962 –theoretical domestic

corporation

§962 tax liability Germany Total§951A /§ 951(a) inclusion 70 70§78 gross up 30 30 ATentative income 100 100§250 deduction -50 -50Net income after deduction 50 50CIT 21% 10.5 BForeign tax credit (lesser of A or B) 10.5 C§962 tax liability 0


§951 INCOME AND THE HIGH TAX EXCEPTION

2 1

• The high tax exception (HTE) kicks out foreign base company income from Subpart F income.

• Must be subject to a high rate of tax which is at least 90% of the U.S. corporate rate (currently 18.9% = 90% *21%).

• Regulations from 2020 apply the HTE to GILTI.

• Exclusion of high taxed income from tested income.

• Applies on an elective basis to non-FBCI. Election is made by controlling domestic shareholder on a timely filed return.

• High tax - determined separately for each tested unit of a CFC. A tested unit includes the CFC itself, an interest in pass through entity, and the activities of a branch.• Departure from item of income approach.

• The compliance burden is lower with the HTE than with the 962 election.

• Decision - Need to determine if there is an opportunity to cross credit.

Indv(U.S.)

Germany

100% of earnings are GILTI

30% corporate tax in Germany.

HTE = kick out all income from tested income

ETR = 44% (30+14)


FOREIGN TAX CREDIT LIMITATION

•The foreign income tax credit is limited to the U.S. tax that applies on each separate category or ‘basket’ of income.

• General – foreign source income not included in another basket

• Passive – foreign person holding company income under §954(c) - interest, dividends, rent, royalties, gains and dividends from a DISC or former DISC.

• Foreign Branch Income

• GILTI

• Income re-sourced by Treaty

2 2


FOREIGN BRANCH INCOME - DEFINITIONS

• FBI: business profits of a U.S. person attributable to a QBU that is a transparent entity in one or more foreign countries.

• Excludes passive category income.

• Income from: • QBUs held directly or indirectly through DREs. • Distributive share of partnership income that is attributable

to partnership foreign branches, direct or indirect DRE activity, or through another passthrough entity held by the partnership with similar income.

• Any other similar income from a pass-through entity

2 3


FOREIGN BRANCH INCOME - DEFINITIONS

• Foreign branch: a QBU that conducts a trade or business outside the U.S..

• QBU: Any separate and clearly identified unit which maintains separate books and records whose activities constitute a trade or business.

• Presumption that QBU exists where activities give rise to a PE under a relevant U.S. income tax treaty.

• Activities of a partnership, estate, or trust that represent a separate trade or business are deemed to be a QBU even if no separate set of books are maintained.

• Required to determine amounts that would be reflected on those books if separate records were maintained.

2 4



FOREIGN BRANCH INCOME – DISREGARDED PAYMENTS

2 6

• Adjustments to income are required for disregarded payments

• Definition: amounts paid to or by a DRE that are disregarded for federal income tax purposes and any other items on books that would be considered income, gain, deduction, or loss if the transaction that they related to were regarded.

• General rules:

• Payment from foreign branch to owner that is allocable to non-passive category: Gross income of foreign branch is adjusted downward and general category income of foreign branch owner is adjusted upward.

• Payment from foreign branch owner to branch allocable to general category: General category income of foreign branch owner adjusted downward and foreign branch income adjusted upward.

Indv(U.S.)

Germany

CTB so Germany is disregarded from a U.S. tax perspective.

German entity is paying U.S. owner wages

Wages 100%


ALLOCATION OF TAXES

• General rule: Taxes are allocated to the income to which they relate. Relationship determined by base on which the tax is imposed by a foreign country.

• If there are preferential rates for certain types of income or credits against certain types of income then those items need to be taken into account.

• If taxes relate to more than one category:

• Foreign tax X (separate category income/total income in foreign tax base).

• Disregarded reallocation transaction – disregarded payment that results in an adjustment of foreign branch income.

• Foreign taxes imposed follow the category of income to which they relate post adjustment.

2 7


BASE AND TIMING DIFFERENCES

2 8

• Base differences – differences in the income tax base - tax imposed on items that are not income under U.S. tax principles (ex – life insurance proceeds).

• Taxes imposed on base differences are allocated to the foreign branch category.

• Possible technical error in the TCJA.

• §904(d)(2)(H)(i) indicates how base differences should be allocated and it contains a reference which was not updated to account for additional categories.

• Regulations clarify that the taxes should be assigned to the category specified in the code.

• Timing differences are not base differences. Where there is a timing difference the taxes imposed are allocated to the appropriate category to which the income relates even though the income will occur in a separate year.

• PTI distributions not taxable under 959 are a timing difference not a base difference. See regulations §1.904-6(a)(1)(iv)

• Where the income under foreign tax principles is greater than under U.S. tax principles (permanent difference) - taxes are still allocated to the category to which the income is assigned and no amount is treated as a base difference.


GILTI BASKET

• GILTI basket income – Any inclusion under §951A other than passive category income.

• Look-through rule: passive category income to the extent the inclusion is attributable to passive category income received by CFC. Example: less than 10% owned partnership income.

• All other 951A income to GILTI basket.

• GILTI FTC limitation – determined on a year by year basis – no carryforwards or carrybacks.

2 9


INCOME RE-SOURCED BY TREATY

• Income that would be U.S. sourced where sourcing is modified by a treaty.

• See relief from double taxation articles. Treaty example: Australia; Ireland

• Re-sourced income is subject to a separate limitation.

• Limitation is applied separately with respect to each treaty for which benefits are claimed and to each separate category of income for each treaty.

• Applies where competent authority assistance allows foreign source treatment.

• Relief for individual U.S. citizens that are residents of treaty countries – separate limitation will not apply.

3 0


HIGH TAXED INCOME

• High taxed income, export financing interest, and financial services income –excluded from passive basket and assigned to the appropriate post-2017 income basket.

• High taxed income

• Foreign taxes paid / deemed paid exceeds highest rate in Section 1 or Section 11.

• Grouping rules of §1.904-4(c)(3) now apply to dividends and inclusions from CFCs, 10% owned FCs, and income from QBUs. Grouping rules – all passive income:

• Subject to 15% or greater w/h tax treated as one item of income.• Subject to w/h tax less than 15% treated as one item of income. • Subject to no w/h tax but subject to another tax as one item of income.

• Subject to no w/h tax or other tax treated as one item of income.

• Not subject to grouping: • Rents and royalties with directly allocable expense; • Partnership income not subject to look-through (less than 10% owned)

3 1


TAXES IMPOSED ON PTEP DISTRIBUTIONS FROM A CFC

• If the income was high taxed then FTCs to appropriate basket.

• If the income not high taxed• Excess of the (Section 11 corporate rate) x (PTI) – (taxes paid

in year of inclusion) is passive.• Remainder to category of income that it would have been

assigned had the income been treated as high taxed in the inclusion year.

• PTEP distributed to successor shareholder • 951(a)(1) – general category income• 951A – GILTI income

• See Regulations §1.904-4(c)(6)(iii)

3 2


ALLOCATION OF EXPENSES

• Expenses are allocated to all income (U.S. and foreign source including §951A income) and on a category by category basis.

• “Factual Relationship” Method

• Used for deductions definitely related to a class of gross income including ‘all gross income’.

• Deduction is incurred “as a result of”, “incident to”, or “in connection with” an activity.

• Stated presumption in the regulations that most expenses are definitely related.

• Gross Income Method

• Required for deductions not definitely related to any gross income.

• Deductions apportioned ratably by gross income based on ratio of gross income by category to total gross income.

• List in regulations of deductions that are not definitely related (not necessarily all inclusive)

• Nonbusiness interest, real estate tax deductions on a personal residence, medical expense deductions, alimony deduction – Reg 1.861-8(e)(9)

3 3


ALLOCATION OF EXPENSES – FACTUAL RELATIONSHIP METHOD

• Factual relationship method applies to (i) deductions definitely related to a class of gross income constituting less than all gross income; and (ii) deductions related to all gross income.

• Method chosen must reflect factual relationship between the deduction and the grouping of income.

• Units sold;

• Amount of gross sales or receipts;

• Cost of goods sold or gross profit contribution;

• Expenses incurred;

• Assets used;

• Space utilized;

• Time spent; and

• Any reasonable method with a factual relationship

• Regulations do not require “best” method; to challenge a chosen method, IRS must show that the method is unreasonable.

3 4


ALLOCATION OF EXPENSES

• Specifically Prescribed Methods

• Interest: §§ 864(e), 1.861-9T, -11T through -13T• Repeal of ‘fair market value’ method. • Tax book value or alternate tax book value are used to apportion interest expense.

• Research and experimentation: § 1.861-17

• State income taxes: § 1.861-8(e)(6)

• Selling general and administrative: § 1.861-8T(b)(3)

• Loss on capital assets: § 1.861-8(e)(7)

• Net operating losses: § 1.861T-8T(e)(8)

• Charitable contributions: § 1.861-8(e)(9) and § 1.861-8(g), example 18

• Loss on sale of personal property: § 1.865-1T

• Loss on sale of stock: §§ 1.865-2 and -2T

3 5

3 6T A X | A U D I T | B U S I N E S S M A N A G E M E N T | M E R G E R S & A C Q U I S I T I O N S

JOHN SAMTOY – INTERNATIONAL TAX PARTNERHCVT LLP

[email protected]

© Aronson LLC | aronsonllc.com |

Foreign Tax Credits for Individuals: Form 1116 Changes,

Final and Proposed Regulations

Alison N. Dougherty, J.D., LL.M., CPADirector, Tax Services

Aronson LLCDecember 10, 2020

© 2020 | All Rights Reserved | Alison N. Dougherty | 38

Form 1116 Foreign Tax Credits for Individuals

Outline

I. I.R.C. § Section 901 Creditable TaxesII. Proposed and Final Regulations III. Sourcing Rules and Grouping of Income into

Baskets IV. Income LimitationsV. Documentation and Substantiation

Requirements and ChallengesVI. Calculating Credits and Carryovers VII. Preparing Form 1116


Form 1116 Foreign Tax Credits for IndividualsReview of Sourcing Rules


Form 1116 Foreign Tax Credit for IndividualsDocumentation and Substantiation Requirements

U.S. Treas. Reg. § 1.905-2(a)(2) Conditions of allowance of a foreign tax credit U.S. taxpayer has an obligation to furnish all receipts of foreign

taxes paid upon request by the IRS. Must maintain receipts of foreign taxes or foreign income tax

returns that verify the foreign tax for which a credit is claimed. U.S. taxpayer has the burden to maintain and produce the

foreign tax return original, duplicate original, duly certified copy, or authenticated copy.

U.S. taxpayer can be required to provide an English translation of the foreign tax return.

The IRS may accept secondary evidence such as copies of checks when the U.S. taxpayer is not able to produce foreign tax payment receipts and foreign tax returns.


Form 1116 Foreign Tax Credit for IndividualsCalculating Credits and Carryovers

FOREIGN TAX CREDIT LIMITATION CALCULATION

Separate limitation required for each income category or basket to prevent taxpayers from overstating foreign tax credits by blending different categories of foreign source income subject to higher and lower foreign tax rates

Foreign source taxable income of category x U.S. federal income tax pre-creditWorldwide taxable income



Separate Limitation Categories of Income I.R.C. § 951A income – GILTI basket Foreign branch income Passive category income General category income I.R.C. § 901(j) income (sanctioned countries) Certain income resourced by treaty Any lump-sum distributions from employer benefit

plan for which special averaging is used to determine the tax



Examples 1(a) and 1(b) – Allocation of Expenses Not Definitely Related to a Specific Category of Income (Form 1116, page one, lines 3 and 4) and Allocation of Foreign Tax to Separate Limit Income Categories

U.S. individual A paid foreign individual income tax in the amount of $3,200 USD on foreign source wages of $80,000 USD and foreign source interest income of $3,000 USD. These were the only items of income on A’s foreign individual income tax return. A also had deductions of $4,400 that are not definitely related to the either the wages or the interest income under foreign law. A’s total net foreign source taxable income is $78,600 ($83,000 - $4,400). It is necessary to calculate the foreign source taxable income in each category by allocating the expenses that are not definitely related to either category of income. For simplicity, it is assumed in this example that U.S. individual A does not qualify for the foreign earned income exclusion on the foreign source wages and that all foreign tax paid on the foreign source wages is creditable not subject to reduction for the exclusion.



Example 1(a) – Allocation of Expenses Not Definitely Related to a Specific Category of Income

General Category:

$80,000 wages x $4,400 expense = $4,241 $83,000 total foreign source income The net foreign source wages are $75,759 ($80,000 - $4,241).

Passive Category:

$3,000 interest x $4,400 expense = $159$83,000 total foreign source income The net foreign source interest is $2,841 ($3,000 - $159).



Example 1(b) – Allocation of Foreign Tax to Separate Limit Income Categories

General Category – The foreign tax on the wages.

$75,759 net wages x $3,200 foreign tax = $3,084 $78,600 total net foreign source taxable income

Passive Category – The foreign tax on the interest.

$2,841 net interest x $3,200 foreign tax = $116$78,600 total net foreign source taxable income



Interest Expense Apportionment - Interest expense is generally apportioned on the basis of assets. Business interest expense – Apportion interest to separate limitation

categories based on the value of the trade or business assets that produce the income.

Investment interest expense – Apportion interest on the basis of investment assets.

Passive activity interest – Apportion interest on the basis of passive activity assets.

Partnership interest – General partners and 10% or greater limited partners classify distributive share of partnership interest based on business, investment, and passive activity interest. Apportion interest expense per distributive share of gross income or partnership assets.

Partnership interest – Less than 10% limited partners directly allocate their distributive share of interest expense to partnership gross income.

Home mortgage interest – Apportion Schedule A mortgage interest per gross income method (business, passive activity, and investment income), exclude income exempt under foreign earned income exclusion



Example 2 – Interest Expense Apportionment

U.S. individual A operates a business as a sole proprietorship. The Schedule C business only produces U.S. source income. A’s investment portfolio consists of several less than 10% stock investments. A has stocks with adjusted basis of $100,000 USD. Some of the stocks with A/B of $40,000 produce U.S. source income. The other stocks with A/B of $60,000 produce foreign source passive income. A owns a home subject to a mortgage of $120,000. A also has a bank loan in the amount of $40,000. The bank loan proceeds were divided equally between the business and the investment portfolio. A’s gross income from the business is $50,000. The investment portfolio produced $4,000 of U.S. source income and $6,000 of foreign passive income during the tax year. All of the debt obligations bear interest at an annual rate of 10%.



Example 2 – Interest Expense Apportionment

Business interest expense apportionment: $20,000/$40,000 loan proceeds attributable to business $20,000 loan x 10% interest rate = $2,000 business interest expense

Investment interest expense apportionment on the basis of investment assets: $20,000/$40,000 loan proceeds attributable to investment portfolio$20,000 loan x 10% interest rate = $2,000 investment interest expense$40,000 A/B U.S. source income investments x $2,000 interest = $800 U.S. source

$100,000 A/B all investments $60,000 A/B Foreign source investments x $2,000 interest = $1,200 foreign source

$100,000 A/B all investments

Home mortgage interest expense apportionment on the basis of all gross income: $120,000 mortgage x 10% interest rate = $12,000 mortgage interest expense $60,000 total gross income ($54,000 U.S. source and $6,000 foreign source passive income)$6,000/$60,000 x $12,000 = $1,200 of home mortgage interest is apportioned to foreign source passive income.



Example 3 – State Income Tax Expense Apportionment State income taxes are definitely related and allocable to the gross income on which the taxes are

imposed. The part of state tax imposed on foreign source income is definitely related and allocable to

foreign source income. If state taxable income is greater than U.S. source federal taxable income then allocate state tax

to foreign source income subject to state tax. If state taxable income is less than U.S. source federal taxable income then do not allocate state

tax to foreign source income since not subject to state tax. If foreign source income is exempt from state tax then state tax is all allocable to U.S. source

income.

U.S. individual A’s total income for U.S. federal tax before deducting state tax is $100,000. Of the $100,000, $25,000 is foreign source income and $75,000 is U.S. source income. A’s total income for state tax purposes is $90,000 on which A pays $6,000 of state income tax. The state does not exempt foreign source income from state income tax. The total state income of $90,000 is greater than the $75,000 of U.S. source income for U.S. federal tax purposes. $6,000 of state income tax is definitely related and allocable to U.S. and foreign source income. It is assumed that $15,000 is foreign source income subject to state tax ($90,000 state taxable income minus $75,000 U.S. source federal taxable income). $1,000 of state income tax is apportioned to foreign source income.

$15,000 foreign source income at state level x $6,000 state tax$90,000 U.S. source and foreign source income at state level

= $1,000 state tax allocable to foreign source income taxed as the state level




Examples 4(a) and 4(b) – Foreign Tax Credit Limitation (with and without I.R.C. § 911 Foreign Earned Income Exclusion)

U.S. individual A had a total of $2M of worldwide taxable income which included $1M of U.S. source taxable income and $1M of foreign source taxable income for the calendar tax year ending 12/31/2018. Of the $1M of foreign source taxable income, $250K was foreign passive income and $750K was foreign wage income. A was subject to a 10% foreign tax rate on the passive income a 40% foreign tax rate on the wage income. Assume that A’s U.S. federal individual income tax rate was 37% for the year. For Example 4(a), assume that A only worked in the foreign country for part of the year and that A did not qualify for the foreign earned income exclusion for the tax year. For Example 4(b), assume that A qualified for the foreign earned income exclusion for the tax year. What is A’s U.S. federal tax liability taking into account the foreign tax credit limitation in the passive and general baskets?



Example 4(a) – Foreign Tax Credit Limitation (without I.R.C. § 911 Foreign Earned Income Exclusion)

$250K foreign passive income x 10% foreign tax rate = $25K foreign tax in passive income limitation category

$750K foreign wage income x 40% foreign tax rate = $300 foreign tax in general income limitation category

$250K foreign passive income x $740 U.S. tax pre-credit $2M worldwide taxable income= $93K foreign tax credit limit in passive basket$25K foreign tax on foreign passive income fully creditable$93K - $25K = $68K is an excess limitation position in passive category for this year

$750K foreign wage income x $740K U.S. tax pre-credit $2M worldwide taxable income= $278K foreign tax credit limitation in general basket $278K of $300K foreign tax paid on foreign wage income creditable$300K total foreign tax paid less $278 general income limitation = $22K foreign tax credit carryforward (or carryback) in the general limitation category

U.S federal individual income tax = $2M x 37% = $740K - $25K FTC (passive) - $278K FTC (general) = $437K



Example 4(b) – Foreign Tax Credit Limitation (with I.R.C. § 911 Foreign Earned Income Exclusion)

$250K foreign passive income x 10% foreign tax rate = $25K foreign tax in passive income limitation category

$750K foreign wage income x 40% foreign tax rate = $300 foreign tax in general income limitation category$750K minus $104K FEIE = $646K foreign earned wage income not excluded $646K x 40% foreign tax rate = $258.4K creditable foreign tax on foreign source wage income

$250K foreign passive income x $701.52K U.S. tax pre-credit $1.896M worldwide taxable income= $92.5K foreign tax credit limit in passive basket$25K foreign tax on foreign passive income fully creditable$92.5K - $25K = $67.5K is an excess limitation position in the passive category for this year

$646K foreign wage income x $701.52K U.S. tax pre-credit $1.896M worldwide taxable income= $239K foreign tax credit limitation in general basket $239K of $258.4K creditable foreign tax paid on foreign wage income not excluded $258.4K total foreign tax paid less $239K general income limitation = $19.4K foreign tax credit carryforward (or carryback) in the general limitation category

U.S federal individual income tax = $1.896M x 37% = $701.52K - $25K FTC (passive) - $239K FTC (general) = $437.52K

Report reduction of foreign taxes attributable to excluded foreign earned income on Form 1116, page 2, line 12



Example 5 – Foreign Tax Credit Limitation The facts are the same as Examples 1(a) and 1(b) except that U.S. individual A also has U.S. source taxable wage income of $200,000 USD. What is A’s foreign tax credit limitation in the passive and general income limitation categories?

U.S. individual A paid foreign individual income tax in the amount of $3,200 USD on foreign source wages of $80,000 USD and foreign source interest income of $3,000 USD. These were the only items of income on A’s foreign individual income tax return. A also had deductions of $4,400 that are not definitely related to the either the wages or the interest income under foreign law. A’s total net foreign source taxable income is $78,600 ($83,000 - $4,400). A’s total worldwide taxable income is $278,600. It is necessary to calculate the foreign source taxable income in each category by allocating the expenses that are not definitely related to either category of income. For simplicity, it is assumed in this example that U.S. individual A does not qualify for the foreign earned income exclusion on the wages and that all foreign tax paid on the foreign source wages is creditable not subject to reduction for the exclusion.



Example 5 – Foreign Tax Credit Limitation: Passive Category

$83,000 total foreign source income - $4,400 allocable expense = $78,600 total net foreign source taxable income

Worldwide taxable income = $278,600($200,000 U.S. source wage income + $78,600 foreign source taxable income)

Assume 35% U.S. federal tax rate on $278,600 of taxable income = $97,510 U.S. tax pre-credit

Passive Income Limitation Category $3,000 interest - $159 allocable expense = $2,841 net foreign source passive interest income

$2,841 net interest/$78,600 total foreign source TI x $3,200 foreign tax= $116 foreign tax allocable to $2,841 of net foreign source passive interest income

$2,841 net foreign source passive interest income x $97,510 = $994 FTC limit $278,600 worldwide taxable income

$116 of foreign tax allocable to foreign source interest income is fully creditable in the passive income limitation category

$994 - $116 = $878 is an excess limitation position in the passive limitation basket



Example 5 – Foreign Tax Credit Limitation: General Category

$83,000 total foreign source income - $4,400 allocable expense = $78,600 total net foreign source taxable income

Worldwide taxable income = $278,600 ($200,000 U.S. source wage income + $78,600 foreign source taxable income)

Assume 35% U.S. federal tax rate on $278,600 of taxable income = $97,510 U.S. tax pre-credit

General Income Limitation Category $80,000 foreign wages - $4,241 allocable expense = $75,759 net foreign source wage income in the general limitation category

$75,759 net wage/$78,600 total foreign source TI x $3,200 foreign tax= $3,084 foreign tax allocable to $75,759 of net foreign source wage income in the general limitation category

$75,759 net foreign source wage income x $97,510 = $26,516 FTC limit $278,600 worldwide taxable income

$3,084 of foreign tax allocable to foreign wage income is fully creditable in the general income limitation category

$26,516-$3,084 = $23,432 is an excess limitation position in the general limitation basket



Examples 6(a) and 6(b)– I.R.C. § 951A GILTI Inclusion with and without the I.R.C. . § 962 election

U.S. individual A is an I.R.C. § 958(a) direct 10% shareholder in a controlled foreign corporation for the entire year in 2018. A’s share of an I.R.C. § 951A GILTI inclusion from the CFC is $1M USD for the tax year. Aalso has U.S. source wage income of $2M USD for the year. The CFC’s foreign corporate income tax rate is 20%. The foreign corporation is a qualified corporation in a treaty country. What is A’s U.S. tax liability after the foreign tax credit with and without an I.R.C. § 962 election?



Example 6(a) – I.R.C. § 951A GILTI inclusion without I.R.C. . § 962 election

$2M U.S. source wage income + $1M GILTI = $3M total worldwide taxable income

U.S. federal income tax liability = {[$2M x 37%] + [$1M x (37% + 3.8% NIIT)]} = $740K + $408K = $1.148M

No foreign tax credit to offset U.S. federal tax on GILTI inclusion



Example 6(b) – I.R.C. § 951A GILTI inclusion with I.R.C. . § 962 election

$2M U.S. source wage income + $1M GILTI = $3M total worldwide income U.S. federal income tax at 37% on $2M U.S. source wage income = $740K Foreign tax on GILTI = $1.25M x 20% = $250,000 (based on inclusion %) I.R.C. § 78 gross up for foreign tax on GILTI = $250K Taxable income from GILTI before I.R.C. § 250 deduction =

$1M + $250K= $1.25M Taxable income from GILTI after I.R.C. § 250 deduction = $625K U.S. federal tax at 21% on taxable income from GILTI = $625K x 21% =

$131K GILTI foreign tax credit subject to 80% limitation = $250K x 80% = $200K Residual U.S. federal income tax on GILTI = $0 ($131K U.S. tax-$131K FTC) No carryforward or carryback allowed for $119K ($250K-$131K) excess

foreign tax on GILTI No excess limitation of $69 ($200K-$131K) allowed in the GILTI basket U.S. tax on distribution of GILTI PTEP $1M x (20% + 3.8% NIIT) = $238K



Example 6 – Summary of U.S. federal tax consequences from I.R.C. § 951A GILTI inclusion with and without I.R.C. . § 962 election

U.S. federal tax without I.R.C. § 962 election = $1.148M U.S. federal tax with I.R.C. § 962 election =

{$740K + [$1M x (20% + 3.8% NIIT)]} = ($740K + $238K) = $978K

U.S. tax savings with election = $1.148M - $978K = $170K


New Form 1116 Foreign Tax Credit for IndividualsCalculating Credits and Carryovers

Example 7 – I.R.C. § 951A GILTI with high foreign tax exception

$2M U.S. source wage income + $1M GILTI = $2M total worldwide taxable income in year when CFC earns the net income, i.e., GILTI

U.S. federal income tax liability = ($2M x 37%)] = $740K U.S. federal income tax liability on distribution of GILTI earnings = {[$1M

x (20% + 3.8% NIIT)]} = $238K Same U.S. tax liability on GILTI earnings as I.R.C. § 962 election

(*assuming 1 CFC)


Form 1116 Foreign Tax Credit for IndividualsCarrybacks and Carryovers

Excess foreign tax credits resulting from limitation are subject to a 1 year carryback and 10 yearcarryover.

Carryback one year first and then carryover for up to 10 years.

Carrybacks and carryovers must be calculated and tracked within each separate limitation category.

Carryback and carryover allowed only to year with excess limitation.

Carryback and carryover are not allowed for unused GILTI foreign tax credits in the GILTI basket.


Form 1116 Foreign Tax Credit for IndividualsCarrybacks and Carryovers

Example 8 – Foreign Tax Credit Carryback and Carryover (Form 1116, page two, line 10)

Year Limit Tax Paid Unused Foreign Tax + / Excess Limit -2017 $200 $100 -$1002018 $300 $500 +$200 2019 $400 $600 +$2002020 $500 $200 -$300

In 2018, there was limited and unused foreign tax of $200 available to carry to other years. The U.S. individual is considered to have paid the unused foreign tax first in 2017 up to the $100 excess limit in that year. There is a carryforward of the remaining $100 of unused foreign tax from 2018 to 2020. The unused foreign tax of $200 from 2019 is also carried forward to 2020 which is the next year with an excess limitation position.


Form 1116 Foreign Tax Credit for IndividualsChanges to 2018 Form 1116

Form 1116 Updates

New separate limit income categories forI.R.C. § 951A GILTI and foreign branch income (Form 1116, page one and page two, Part IV)

Revised sourcing rule for certain income from the sale of inventory under I.R.C. § 863(b)

Election to increase I.R.C. § 904(g)(5) pre-2018 Overall Domestic Loss (ODL) recapture

For 2018, a subtraction is not allowed for personal exemptions in the foreign tax credit calculation.

Transition rule for carryovers of foreign tax and loss for branch basket



I.R.C. . § 863(b) Sourcing for Sales of Inventory

For tax years beginning after 12/31/2017, source income from sale of produced inventory based 100% on the location of production.

Rule applies for inventory produced in part within and without the United States.

Example A – Income from sale of inventory in a foreign country is entirely U.S. source if produced entirely in the United States regardless of where title passes.

Example B – Income from sale of inventory is entirely foreign source if entirely produced outside the United States even if title passes in the United States.

Income from sale of inventory is in part U.S. source and in part foreign source if production occurs within and without the United States.



I.R.C. § 904(g) ODL Recapture Election I.R.C. § 904(g)(5) election allows recapture of 100% (instead of 50%) of

unused pre-2018 ODL from a prior year. The election is applicable for any taxable year beginning after

December 31, 2017 and before January 1, 2028. ODL = Overall domestic loss that offsets foreign source taxable income

in a year that the individual claims the foreign tax credit or any prior year that a carryback is claimed.

ODL requires that U.S. source taxable income is recharacterized as a foreign source taxable income in subsequent years for purposes of calculating the foreign tax credit.

The recaptured amount is the lesser of: The total balance of the ODL account in each separate category

less amounts recaptured in earlier years, or 50% of the U.S. source taxable income for the year.

Must allocate the recharacterized foreign source taxable income in each category in proportion to ODLs in each category.

Increase amount on Form 1116, page two, line 15 for each of the separate categories to which the recharacterized income is allocated.







Resources TCJA T.D. 9922 Proposed Regulations REG-101657-20 T.D. 9882 Proposed Regulations REG-105495-19 Proposed Regulations REG-105600-18 U.S. Federal Form 1116 Foreign Tax Credit for

Individuals IRS Form 1116 Instructions IRS Publication 514

© 2020 | All Rights Reserved | Alison N. Dougherty |

ALISON N. DOUGHERTY, J.D., LL.M., CPADirector, Tax ServicesAronson LLC

Alison N. Dougherty provides tax services as a Director at Aronson LLC.She specializes in U.S. international tax reporting, compliance,consulting, planning, and structuring. She has extensive experienceassisting clients with U.S. tax reporting and compliance for offshoreassets and foreign accounts. She provides outbound U.S. internationaltax guidance to U.S. individuals and businesses with activities in othercountries. She also provides inbound U.S. international tax guidance tononresident individuals and businesses with activities in the UnitedStates. She has worked extensively in the area of U.S. international taxreporting and compliance with the preparation of the U.S. FederalForms 5471, 8992, 8993, 926, 8865, 8858, 5472, 1042, 1042-S, 8621,8804, 8805, 8813, 8288, 8288-A, 8288-B, 1116, 1118, 1120-F, 1040-NR,3520, 3520-A, 2555, 5713, 8832, 8833, 8840, 8843, 8854, 8938, andFBAR. She has counseled U.S. taxpayers regarding the outboundformation, capitalization, acquisition, operation, reorganization, andliquidation of foreign companies. She has significant experience withU.S. Federal nonresident tax withholding, foreign partner taxwithholding, and FIRPTA withholding. She works closely withnonresident individuals and businesses regarding inbound U.S. realproperty investment. She has assisted U.S. taxpayers with IRS amnestyprogram disclosures of offshore assets and foreign accounts.

Alison completed the LL.M. (Master of Laws) in Securities andFinancial Regulation in 2004 with academic distinction at GeorgetownUniversity Law Center. She completed the LL.M. (Master of Laws) inTaxation in 2000 and the Juris Doctor in 1999 at the University ofDenver College of Law. She completed a Bachelor of Arts degree inForeign Language in 1995 at Virginia Commonwealth University.

(301) [email protected]

Aronson LLC111 Rockville PikeSuite 600Rockville, Maryland 20850 USAWashington, DC Metro Area

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