Foreign Tax Credit Utilization for Corporations: Calculations

Foreign Tax Credit Utilization for Corporations:

Calculations, Schedules and Considerations for Form 1118

THURSDAY, APRIL 30, 2015, 1:00-2:50 pm Eastern

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Foreign Tax Credit Utilization for Corporations

April 30, 2015

Cory Perry

Grant Thornton

[email protected]

Robert J. Misey, Jr.

Reinhart Boerner Van Deuren

[email protected]

William R. Skinner

Fenwick & West

[email protected]

David Weiner

Grant Thornton

[email protected]





Notice

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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.

Fenwick & West LLP

Silicon Valley Center

801 California Street

Mountain View, CA 94041

Phone: 650.988.8500

www.fenwick.com

Foreign Tax Credit

Utilization – Source of

Income and Allocation

of Expense

Strafford Publications

Webinar

April 30, 2015

William R. Skinner, Esq.

[email protected]

7

William R. Skinner, Esq. is a tax

partner with Fenwick & West LLP, in

Mountain View, CA. He focuses his

practice on U.S. international and

corporate tax matters, including

international tax planning, tax

controversies, and the taxation of

financial instruments. He received his

JD from Stanford Law School with

distinction, and BA from University of

California at Berkeley. More

information about his practice is

available at www.fenwick.com. He can

be contacted at [email protected]

and 650-335-7669.

William R. Skinner

Partner, Tax Group

Phone: 650.335.7669

Fax: 650.938.5200

E-mail:

[email protected]

Emphasis:

International Tax

Tax Planning

Tax Controversy

Corporate/Transactional Tax

http://www.fenwick.com/


8

Overview –

Relevance of Sourcing Income and Allocating Expense

Sourcing Common Types of Corporate Income

Allocation and Apportionment of Expenses

9

Relevance of Sourcing Income and

Allocating Expense

10

Foreign Tax Credit (FTC) Overview

The FTC is used to avoid double taxation of a US

resident’s foreign income.

The FTC limitation (§ 904(a)) is designed to ensure that

foreign taxes may be credited only against U.S. taxes that

are imposed on foreign income, not US income.

Under § 904(a), the foreign tax credit is limited to the

following amount:

Foreign Source Taxable Income

Worldwide Taxable Income

Tentative

U.S. Tax

Liability

x = FTC Limit

11

The Overall FTC Limitation

Example 1:

U.S. taxpayer has $500 of taxable income for its 2014 taxable

year ($250 derived from U.S. sources and $250 derived from

foreign sources).

• France levies taxes on the taxpayer totaling $97.

• Taxpayer’s U.S. federal income tax liability before the foreign tax

credit is $175 (35% rate).

$250 Foreign Source Income

$500 Worldwide Income

$175

Tentative

U.S. Tax

Liability

x = $87

FTC Limit

The taxpayer’s FTC is limited to $87, leaving the taxpayer with $10 of

unused FTC. The taxpayer’s U.S. tax liability is $88 following the

application of § 904 ($175 - $87).

12

The Overall FTC Limitation

Example 2:

Assume instead that $280 of the taxpayer’s taxable income is derived

from foreign sources pursuant to the source of income provisions.

$280 Foreign Source Income

$500 Worldwide Income

$175

Tentative

U.S. Tax

Liability

x = $98

FTC Limit

The taxpayer is now able to fully utilize its creditable foreign taxes paid

of $97.

By increasing the amount of foreign source taxable income by $30, the

taxpayer was able to avoid double taxation with respect to its foreign

source income. The taxpayer’s U.S. tax liability is $78 ($175 - $97).

13

Section 904(d) Separate Baskets

Section 904(d) requires that taxpayers apply the § 904

limitation separately to two different categories of foreign

source income (“baskets”): the “passive basket” and

“general basket.”

Taxpayer determines taxable income (net of deductions)

in each separate basket, then apply the § 904 formula, to

the net income in that basket and taxes imposed on that

basket.

14

A, a domestic corporation, earns $500 of foreign source income and

pays $140 of foreign tax. A has $1,000 of worldwide income and has

a U.S. tax liability (pre-credit) of $350. A’s foreign source income

and tax is allocated to the FTC baskets as follows:

Passive income: $200 income $ 20 tax (10% Rate)

General income: $300 income $120 tax (40% Rate)

$500 $140 (28% Rate)

Example

A’s FTC limitation must be computed separately with respect to the

baskets of income:

Passive basket: ($200/1,000) x $350 = $70

General basket: ($300/1,000) x $350 = $105

15

The Separate Baskets – Definition of Passive Income

Passive income means “passive income” and “specified passive income” (rare)

Passive Income generally means any income received or accrued by any

person which is of a kind which would be FPHCI (as defined in

§ 954(c)) if derived by a CFC.

FPHCI includes:

• Dividends, interest, royalties, rents, annuities, and gain from the sale

of property that produces such income (e.g., capital gains).

• Gain from the sale of property, which does not generate income, as

well as sales of certain interests in partnerships and trusts.

• Certain foreign currency gain, interest equivalents, income from

notional principal contracts, and certain payments in lieu of dividends.

Exceptions:

• active rents and royalties exception

• export financing interest, and

• high-taxed income.

16

Sourcing Common Types of

Corporate Income

17

Overview of Source of Income Rules

Sourcing Interest, Dividends, Rents and Royalties

Sourcing Sales of Inventory Property

Non-Manufactured Property

Manufactured Property

Sourcing Sales of Non-Inventory Property

Sourcing Services Income

18

Interest, Dividends, Rents and Royalties—

General Rules

Interest income and dividends generally are sourced to

residence of the obligor or dividend distributing company,

respectively. See §§ 861(a)(1)(A), 861(a)(2), 862(a)(1),

and 862(a)(2).

Rents and royalties are sourced to the place of use of the

property. §§ 861(a)(4) and 862(a)(4).

In the case of interest, dividends, rents and royalties paid

by a related CFC to its U.S. shareholder, a favorable

“look-through rule” sources and characterizes the income

based on the payor’s underlying income. See Section

904(d)(3).

19

Source of Interest Income

Example

Since CFC is a non-US resident, the residence of the

obligor and source of interest payment is foreign.

In addition, under § 904(d)(3), interest is “general basket”

income eligible for cross-crediting to the extent properly

allocable to general basket income of the payor CFC.

USP

CFC

Intercompany

Loan

Interest

20

Source of Rents and Royalties—

Place of Use

There is no definition of “place of use” in the Code.

The IRS has generally looked to the place where the

legally protected use of the IP occurs. For example:

Rev. Rul. 68-443 (foreign source TM royalties where only

foreign rights licensed; despite the fact that licensee affixed

the TMs to products at a US facility)

Rev. Rul. 72-232 (similar for copyrighted textbooks)

Rev. Rul. 84-78 (rights to make a live broadcast of US

boxing match in a foreign audience were foreign source)

But see Sanchez v. Comm’r, 6 T.C. 1141 (1947) (US

company’s patent royalties for products made in the U.S.,

but sold abroad were entirely U.S. source).

21

Sourcing Sales of Inventory Property—

Overview

Inventory property is subject to two separate sourcing

rules:

Place of sale/ “Title passage rule” for inventory

purchased for resale (§§861(a)(6) and 862(a)(6))

Mixed sourcing under § 863(b) for inventory

manufactured by the taxpayer, including:

• Export property manufactured within the US and sold

outside the US

• Import property manufactured outside the U.S. and sold

within the US

Sale of Inventory

Title Passage Rule

Sale of inventory by a non-producer is sourced where title

and risk of loss to the goods pass. Reg. § 1.861-7(c).

Seller may retain “bare legal title” to the goods after sale.

Thus, terms affecting beneficial ownership (e.g.,

insurance, freight expense) are important to establish the

place of sale.

INCOTERMS are used to effect title passage at particular

places. For example:

Ex Works (EXW) – buyer has risk of loss from time goods are

placed at buyer’s disposal at the seller’s facility

Free Carrier (FCA) – seller delivers goods to a common carrier,

and passes ownership to buyer upon delivery to carrier.

Delivered Duty Paid (DDP) – seller has risk of loss until goods

clear customs and are delivered to buyer 22

Sale of Inventory

Title Passage Rule

US French

Customer Inventory

Place where title & risk of loss

pass:

Source of income:

At US Place of Shipment US

While in Transit Across the

Atlantic

Foreign

Upon Delivery to the French

Customer

Foreign

23

Sale of Manufactured Inventory

Production and Sale

Section 863(b) governs inventory produced within the

US and sold outside the US (or vice versa).

Gross income must be dividend between the production

function and selling function under one of three different

methods:

1. A 50-50 division of gross income between production and

selling (“50/50 method”)

2. A division based on prices charged to independent distributors

(“IFP method”) in which the US Parent performs no selling

activities.

3. A division based on taxpayer’s internal books and records

(with IRS consent).

24

Sale of Manufactured Inventory

Example of 50/50 Method

Under 50/50 method, USP earns $30 of gross income attributable to

manufacturing and $30 attributable to sales.

Manufacturing income is sourced to the location of USP’s production

assets (likely 100% US).

Sales income is sourced under the same title passage rule as for

inventory for resale (likely foreign).

USP Foreign

Person

$100 Gross Receipts

($40) COGS

$100

Manufactured

Inventory

$60 Gross Income

US

Factory

25

Sales of Non-Inventory Property

Section 865 provides source rules for sales of non-

inventory property that depend on the nature of property

sold:

§ 865(a) – general rule is residence of the seller

§ 865(c) – recapture rule for depreciable property sources based

on allocation of prior depreciation deductions

§ 865(d) – rules for intangible property

• Gains contingent on use, productivity or disposition of IP are sourced like

royalties (place of use)

• Goodwill is sourced to the place where it is “generated” (location of business)

Sales of CFC stock

• § 1248 amount – sources as a foreign source dividend to the extent of

underlying E&P

• § 865(f) – foreign source, passive basket treatment for certain sales of stock in

foreign affiliates

26

Source of Services Income

Services income is sourced to the place where the services

are performed – generally, where employees or other

agents are physically located while performing the

services. See §§ 861(a)(3) and 862(a)(3).

In cases where the relevant services are performed inside

and outside the U.S., the income must be apportioned

based on a metric that accurately reflects the source of

income.

In many cases, the time basis, adjusted for payroll cost of

different employees, will be acceptable. Reg. § 1.861-4(b)(1);

Tipton & Kalmbach, 480 F.2d 1118 (10th Cir. 1973).

If an alternative method is used, the taxpayer must maintain

documentation to substantiate why the method was chosen. See

Reg. § 1.861-4(b)(2)(ii)(C)(i).

27

Slide Intentionally Left Blank

29

Allocation and Apportionment of

Expenses

30

Overview

Allocation and Apportionment for Sales, General &

Administrative and other Supportive Expenses under Reg.

1.861-8

Allocation and Apportionment of Interest Expense

Allocation and Apportionment of Research and

Experimentation Expense

Allocation of Expenses

General and Supportive Expenses

The regulations provide a two-step approach:

1) Allocate the deduction to the class or classes of gross income

with which it is factually related.

2) Apportion the deduction between United States and foreign

source income in the class.

§ 1.861-8(a)(2).

Examples:

Sales manager’s salary.

Amounts paid as shareholder oversight to protect investment in

foreign subs (“stewardship”).

Salary of IP management department.

31


General and Supportive Expenses

Deductions are then apportioned between United States and foreign-

source income within the class based on the factual relationship

between the expense and the gross income.

Different apportionment keys can be used, so long as the key chosen

reasonably reflects the factual relationship between the expense and the

type of income:

units sold;

gross receipts;

COGS;

Gross Margin;

amount of other expenses allocated to classes; and

gross income.

See § 1.861-8T(c)(1).

32


General

U.S.

Sales $750

GI $300

Example 19 – absent time records, salary expense could

reasonably be apportioned based on revenue or gross income.

Example 20 – if CEO and sales manager do maintain time

records, then that direct evidence will be preferred to

apportionment keys such as gross income or revenue.

U.S. Dept Foreign Dept

Sales Manager & CEO

Sales $500

GI $200

33

Interest Expense

Regulations allocate interest expense based on the

approach that “money is fungible” and interest expense

supported by all of the taxpayer’s assets.

Thus, interest expense of a domestic corporation must be

apportionment between US and foreign sources based on

the relative value of US and foreign assets of the domestic

corporation.

Asset value generally is determined under the “tax book

value” method. However, taxpayer may make a one-time

binding election to apply other methods:

“Alternative” tax book value

Fair market value method 34

Interest Expense –

Tax Book Value Adjustments

Reg. 1.861-12(c) / -12T(c) requires a US shareholder’s

basis in a 10% or greater owned foreign corporation’s

stock to be increased by the accumulated E&P of the

corporation during the shareholder’s holding period.

35

Interest Expense Allocation - Example

Assets

Category Tax Basis FMV

Domestic $3000 $3,200

Foreign $600 $800

Total $3,600 $4,000

Foreign % 16.6% 20%

US Co $100 Interest

Expense

Foreign

HoldCo

36

The regulations provide for an allocation based on broad 3-

digit SIC Codes.

All income “reasonably connected with” the 3-digit SIC

Code must be allocated R&E expense from that product

category.

Narrower product classifications cannot be used. See

Boeing Co. v. United States, 537 U.S. 437 (2003).


R & E / § 1.861-17

37

Taxpayers can elect to apply either the gross income

method or sales method to apportion R&E expenses.

The election is made for the first relevant taxable year and

is binding for four years thereafter.

See § 1.861-17(e)(2).


R & E / § 1.861-17

38

Under either method, a portion of R&E is exclusively

apportioned to the country where the research was

predominantly performed.

The percentage is generally 50% under the sales method

and 25% under the gross income method.

The taxpayer can justify a larger percentage by proving the

research meets U.S. regulatory requirements or has long-

delayed application abroad. See Reg. § 1.861-17(b)(2).


R & E / § 1.861-17

39

Sales method of Apportionment:

Taxpayer includes its own gross receipts from the product category.

It also includes gross receipts of licensees from sale of licensed

products in the following manner:

• For controlled licensees, include a proportionate amount of sales from

the product category.

• For unrelated licensees, include all sales of licensed products / an

estimate of sales of licensed products.

See Treas. Reg. § 1.861-17(c)(2)(i) & (ii).


R & E / § 1.861-17

40


R & E / § 1.861-17

U.S.

F

$60 R&E on Engines

(Category 351)

Treas. Reg. § 1.861-17(h), Example 1

$500 Domestic

Engine Sales

$300 Foreign

Engine Sales

100%

41

Sales-based apportionment:

Step 1: Exclusive apportionment of 50% of R&E performed within

the U.S. ($30) to U.S. sources.

Step 2: Determine relevant sales within the Engines product

category: U.S. — $500; Foreign — $300

Step 3: Apportion the remaining $30 not apportioned in Step 1 based

on source of Engine Sales (i.e., 5/8 U.S.).

Result: U.S. Expense — $18.750 ($30 * 5/8)

Foreign Expense — $11,250 ($30 *3/8)


R & E / § 1.861-17

42

The Gross Income Method of Apportionment:

The gross income method apportions R&E based on relative amounts of

the U.S. taxpayer’s gross income in each product category, rather than

sales revenue of US taxpayer and affiliates.

The amount sourced based on geographic location of the R&E is only

25%, instead of 50%.

The amount allocated to U.S. or foreign sources cannot fall below 50%

of the sales-method calculation (the “sales floor”). See § 1.861-17(d).


R & E / § 1.861-17

43


R & E / § 1.861-17


R & E / § 1.861-17

U.S.

F

$60 R&E on Engines (SIC 351)

Treas. Reg. § 1.861-17(h), Ex. 1

$140 U.S. Sales

Income

$10 U.S. Interest

Income

$10 FS Royalties

$160 Total Gross

Income

License of Engine Technology

Royalties

44

Gross income method:

Step 1: Exclusive apportionment of $15 (25%) to place where

R&E is performed.

Step 2: Determine relevant gross income in the product category:

Domestic Sales Income-$140; Foreign Royalties-$10.

Note $10 of U.S. Interest Income is excluded.

Step 3: Apportion remaining $45 not apportioned in Step 1 based

on relative amounts of gross income:

U.S. = $42 ($45 x $140/$150)

Foreign = $3 ($45 x $10/$150)


R & E / § 1.861-17

45

Gross income method continued:

Step 4: Tentative apportionment to U.S. = $57

Tentative apportionment to Foreign = $3

Step 5: Apply “Sales Floor” Calculation:

Foreign expense under sales method = $11.250

50% “Sales Floor” = $5.625

Result: Foreign — $5,625 (Greater of Steps 4 and 5)

U.S. — $54,375


R & E / § 1.861-17

46


Foreign Tax Credit Utilization

for Corporations Presented by

Robert Misey

Chair, International Department

Reinhart Boerner Van Deuren, s.c.

April 30, 2015

The Three Types of

Foreign Tax Credits 1. The direct foreign tax credit

I.R.C. § 901

2. The indirect foreign tax credit also known as

the deemed paid credit

I.R.C. § 902

3. The foreign tax credit for a tax in lieu of an

income tax (considered a type of direct

foreign tax credit)

I.R.C. § 903

©2015 All Rights Reserved

Reinhart Boerner Van Deuren s.c. 49

Framework of Analysis

for Every Foreign Tax Credit Issue

1. Determine the foreign income taxes

("FITs")

2. Determine the foreign tax credit

limitation

3. The foreign tax credit is the lower of

the FITs or the limitation



The Predominate Character of the

Foreign Levy Must Be that of an

Income Tax in the U.S. Sense

1. The Realization Requirement

2. The Gross Receipts Requirement

3. The Net Income Requirement



Case Study 1

The Direct Foreign Tax Credit


Reinhart Boerner Van Deuren s.c.

U.S.

Foreign

Asia

Branch

USAco

$10 million foreign-source taxable income

$2.5 million FITs

52

Case Study 2

Credits for a Tax in Lieu of an

Income Tax



U.S.

Foreign

USCo

$10 million dividend less

$2.5 million withholding taxes

FCorp

53

Case Study 3

Limitations on the Foreign Tax Credit



U.S.

Foreign $ 3 million foreign-source taxable income

$ 1.6 million FITs

US

USAco

Foreign Activity

$10 million worldwide taxable income

$ 7 million U.S.-source taxable income

54

The Formula for the Limitation

Pre-credit U.S. tax on WWI x Foreign-source taxable income

Worldwide

taxable income

or

Pre-credit U.S. tax on foreign-source taxable income



The Basket Limitations

1. The Passive Basket

2. The General Basket



Case Study 4

The Overall Limitation



U.S.

Foreign $10 million foreign-source taxable income

$ 8 million general limitation income

($3 million FITs)

$ 2 million passive limitation income

($500,000 FITs)

USAco

Foreign Activity

and Investment

$22 million worldwide taxable income

$12 million U.S.-source taxable income

57

Case Study 4

The Overall Limitation (cont.)



Foreign income taxes [$ 3 million + $500,000 ] ........................ $3.5 million

Foreign tax credit limitation :

(A) Worldwide taxable in come

[ $1 2 million + $8 million + $2 million] .................... $22 million

(B) Pre - credit U.S. tax [$ 22 million x 35%] .................. $ 7.7 million

(C) Foreign - source taxable income

[ $ 8 million + $2 million] ................................ ........... $10 million

Limitation = [line B x (C ÷ A)]

= [$ 7.7 million x ($1 0 million ÷ $22 million) ] ... $ 3.5 million

F oreign tax credit (equals foreign income taxes) ..................... $ 3.5 million

58

Passive Basket Income

1. Dividends

2. Interest

3. Rents

4. Royalties



Case Study 5

The Basket Limitations



General income: Foreign income taxes on general income ................................ ..... $3 million

Foreign - source general income ................................ ............... $8 million Limitation = [$7.7 million x ($8 million ÷ $22 million)]

= $2.8 million General FTC [equals the limitation] ................................ ... $2.8 million Passive income: Foreign income taxes on passive income ................................ ...... $500,000

Foreign - source passive income ................................ ............... $2 million Limitation = [$7.7 million x ($2 million ÷ $22 million)]

= $700,000 Passive FTC [equals foreign income taxes] ............................. $500,000 Total FTC is $2.8 million general + $.5 million passive .......... $3.3 million

60

Deferral of Income Earned by FSub



US Parent

USSub

US

F

FSub F Branch

61

Dividends Received Deduction

Eliminates Double Taxation



US Parent

USSub

Dividend

62

No Dividends Received Deduction for

Dividend From Foreign Subsidiary



US Parent

FSub

Dividend

63

Case Study 6

Deemed-paid and 903 Credits



USAco

FORco

5% withholding

$1 million taxable income

$250,000 foreign taxes

U.S.

Foreign

$750,000

64

Case Study 7

The Direct Foreign Tax Credit



USAco

Asia

Branch


$2.5 million FITs

U.S.

Foreign

1. FITs: $2.5 million

2. Limit: (pre-cr U.S. tax on WWI) x FSI = (35% of $10 million)

WWI

3. FTC: $2.5 million

$10 million

$10 million = $3.5 million

65

Case Study 8

The Deemed-Paid Foreign Tax Credit



USAco

ASIAco


$ 2 million foreign taxes

$ 8 million e&p

U.S.

Foreign

$8 million dividend

1. FITs: $2.5 million x = $2.5 million

$7.5 million $7.5 million

2. Limit: (35% of $7.5 million + $2.5 million)

$7.5 million + $2.5 million $7.5 million + $2.5 million

3. FTC: $2.5 million

= $3.5 million

66

The Amount of the Deemed‐Paid Credit



Foreign corporation's

post-1986 foreign

income taxes x

Dividend

Foreign corporation's

Post-1986 undistributed E&P

67

Case Study 9

Distributing Half the E&P



USAco

ASIAco

$10 million foreign-source taxable

income

$2.5 million foreign taxes

$7.5 million e&p

U.S.

Foreign

$4 million dividend

1. FITs: $2.5 million x = $1.25 million

2. Limit: (35% of $3.75 million + $1.25 million) 3. FTC: $1.25 million

$3.75 million + $1.25 million $3.75 million + $1.25 million

$3.75 million $7.5 million

= $1.75 million

68

Case Study 10

How Should We Pool?



USAco

EURco

U.S.

Foreign

$3 million dividend in year 2

69

Case Study 10

The Pooling of Taxes and Earnings (cont.)



Pre-tax Foreign Effective Earnings & Dividend

Year Earnings Income Taxes Foreign Rate Profits Distributions

Year 1 $10 million $2 million 20% $ 8 million $0

Year 2 $10 million $3 million 40% $ 7 million $3 million

$5 million $15 million

Pooling: $3 million x $5 million = $1 million $15 million

70

Case Study 11

Multiple Tiers



USAco

FORco1

FORco2

U.S.

Foreign 100%

40%

FORco3

10%

71

Case Study 12

More Multiple Tiers



US

F1

F2

US

F

30%

20%

F3

10%

72

Case Study 13

The Amount of FITs from Multiple Tiers



USAco

F1

F2

$2 million dividend

$2 million dividend

$6 million E&P

$3 million FITs

$18 million E&P

$4 million FITs

U.S.

Foreign

73

Case Study 13 (cont.)

The Amount of FITs from Multiple Tiers



USAco

F1

F2

$2 million dividend

$1.5 million FITs

$2 million dividend

$6 million E&P

$3 million FITs

$18 million E&P

$4 million FITs

U.S.

Foreign

$20

$5

$4

$2

$18

$4.5

74

Case Study 14

Look-Through Rules for CFCs



U.S.

Foreign

$10 million accumulated e&p

$9 million general limitation e&p

$1 million passive income e&p

US

USAco

FORco

75

Other Issues

1. Basketing of FITs

2. Credits for Subpart F Inclusions

3. Proof of Foreign Income Taxes



Case Study 15

Proof of Foreign Income Taxes



1990 : FORco Incorporated

December 31, 2013 : FORco Distributes Dividend

June, 2015 : IRS Audits USAco

77

Robert Misey Robert Misey is Chair of the International Department for Reinhart Boerner Van Deuren s.c. When previously with the IRS Chief Counsel (International) in Washington, he litigated foreign tax credit cases. He has also authored A Practical Guide to U.S. Taxation of International Transactions. Robert can be reached via phone at either 312-207-5456 or 414-298-8135 or via e-mail at [email protected]

31834417




© Grant Thornton LLP. All rights reserved.

FOREIGN TAX CREDIT

UTILIZATION FOR

CORPORATIONS:

CALCULATIONS, SCHEDULES AND

CONSIDERATIONS FOR FORM 1118

April 30, 2015


Disclaimers

CIRCULAR 230

Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax

structure of any matter addressed herein. To the extent this document may be considered to contain written tax

advice, any written advice contained in, forward with, or attached to this document is not intended by Grant Thornton

to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the

Internal Revenue Code.

Tax Professional Standards Statement

This document supports Grant Thornton LLP’s marketing of professional services, and is not written tax advice

directed at the particular facts and circumstances of any person. If you are interested in the subject of this document

we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular

situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment

or tax structure of any matter addressed herein. To the extent this document may be considered to contain written

tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant

Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed

under the Internal Revenue Code.


Presenters

Cory Perry | International Tax Consulting - Manager

Grant Thornton LLP

757 Third Avenue, 9th Floor

New York, NY | 10017 | United States

T (direct) +1 212 542 9909

E [email protected] | W www.grantthornton.com

David Weiner | International Tax Services Senior Manager

Grant Thornton LLP

757 Third Avenue, 9th Floor

New York, NY | 10017 | United States

E [email protected] | W www.grantthornton.com


Agenda

83

V. Redetermination of Foreign Tax I. History of Section 905(c)

II. "Foreign Tax Redetermination" Events

III. Direct Credit

IV. Indirect Credit

V. Notification of Foreign Tax Redetermination under Treas. Reg. Section 1.905-4T

VI. E&P Adjustments

VII. Other Considerations

VI. Special Treaty Provisions I. Foreign Tax Credit Treaty Provisions

II. Creditable Taxes That Otherwise May Not Be Considered Income Taxes

III. Sourcing Rules (Resourcing)

IV. Competent Authority


Redetermination

of Foreign Tax


Redetermination of Foreign Tax

85

• Section 905(c) provides guidance for situations when the amount of

foreign taxes claimed as either a "Direct Credit" under Section 901 or

an "Indirect Credit" (deemed paid credit) under Section 902 or

Section 960 are increased, refunded or otherwise adjusted.

• Section 989(c)(4) permits the IRS to issue regulations providing

alternatives to such redeterminations.

• In November 2007, the IRS issued temporary and proposed

regulations. The temporary regulations sunseted in November of 2010.

• The proposed regulations remain outstanding, and the IRS has

indicated that the 2007 regulations may be relied on until final

regulations are issued (See CCA 201145015).

History of Section 905(c)


Foreign Tax Redetermination Events

86

• In general, Section 905(c) provides a mechanism for adjusting the

amount of foreign taxes claimed, or available to be claimed, as a credit

when a U.S. Taxpayer pays or accrues a foreign tax and the amount of

that foreign tax liability subsequently changes.

• A "foreign tax redetermination” event may occur in any of four basic

patterns.

Overview

The triggering event of Section 905(c) is referred to in the regulations as a

“foreign tax redetermination” (See Temp. Reg. § 1.905-3T(c)).


Foreign Tax Redetermination Events

87

Foreign Tax Redetermination Events (hereafter "FTR Event") :

(1) Taxes that when paid differ from the amount accrued (e.g., over-

accrual).

(2) Accrued taxes that are not paid before the date two years after the

close of the tax year to which such foreign tax credits relate.

(3) Taxes that are refunded in whole or in part.

(4) Taxes that are taken into account when accrued but translated into

dollars on the date of payment, and there is a difference between the

dollar value of the accrued tax and the dollar value of the tax paid

attributable to fluctuations in the value of the foreign currency relative

to the dollar between the date of accrual and the date of payment.

Events


Direct Credit

88

If a FTR Event occurs with regard to a Direct Credit, the "Relation Back

Doctrine" generally applies (Cuba Railroad Co. v. United States, 124 F.

Supp. 182).

Accordingly, the Taxpayer must recalculate the foreign tax liability as a

result of the FTR Event in the respective year(s) adjusted ("Relation

Back Adjustment"). The Relation Back Adjustment is made by:

(1) Amending the tax return to include an amended Form 1118, Foreign

Tax Credit – Corporations or Form 1116, Foreign Tax Credit – Individual,

Estate, or Trust; and,

(2) Notifying the IRS of the FTR Event with a Treas. Reg. Section 1.905-

4T(c) notification statement for the tax year with respect to which a

determination of U.S. tax liability is required.

Consequences of a Redetermination Event


Direct Credit

89

• No redetermination of U.S. tax liability is required with respect to a

FTR Event if the amount of the redetermination is less than (1)

$10,000 or (2) two percent of the total dollar amount of the foreign tax

initially accrued with respect to that foreign country for the tax year,

whichever is less.

• If applicable, the adjustment shall be made to the taxpayer's United

States tax liability in the taxable year during which the FTR Event

occurred.

Exception


Indirect Credit

90

If an FTR Event occurs with regard to an Indirect Credit, the Relation

Back Doctrine may not apply (subject to four exceptions discussed on the

following slide).

An FTR Event that occurs after the tax return for the affected year has

been filed should be reflected in a forward adjustment to the foreign tax

credit ("FTC") and earnings and profits ("E&P") pools ("Pool

Adjustment") rather than on an amended return for the year to which the

FTR Event adjusts. The Pool Adjustment is made by:

(1) Update the E&P and FTC Pools.

(2) Notifying the IRS of the FTR Event by reflecting the adjustments to

the FTC and post-1986 E&P pools on Form 1118, Foreign Tax Credit –

Corporations for the Tapxpayer's first taxable year which the

redetermination affects the computation of foreign taxes deemed

paid.



Indirect Credit

91

Exceptions to the Pool Adjustment are as follows (Treas. Reg. Section 905-

3T(d)(3)):

(1) The foreign tax liability is in a "hyperinflationary currency."

(2) The FTR Event reduces by ten percent or more the domestic

corporate shareholder’s Indirect Credit. Taxpayer must calculate to

determine what would be the impact if the Relation Back Adjustment

is applied to determine the ten percent reduction.

(3) The FTR Event creates a deficit in the FTC Pool.

(4) A domestic corporate shareholder of a controlled foreign corporation

("CFC") receives a distribution from the CFC of previously taxed

earnings and a foreign country, which initially taxed the distributed

earnings, refunds some or all of this tax by reason of the distribution.



Indirect Credit

92

If an exception to the Pool Adjustment applies for an FTR Event

adjusting Indirect Credits, the Taxpayer must adjust for the FTR Event in

the respective year(s) affected using the Relation Back Adjustment

approach. Similarly to the Direct Credit procedures discussed, the

Relation Back Adjustment is made by:

(1) Amending the tax return to include an amended Form 1118, Foreign

Tax Credit – Corporations, and

(2) Notifying the IRS of the FTR Event with a Treas. Reg. Section 1.905-

4T(c) notification statement for the tax year with respect to which a

determination of U.S. tax liability is required.



Notification of Foreign Tax Redetermination

93

Pooling and Relation Back Adjustments – Tax years after 2007

Type of

Adjustment Notification Process Content of Notification Timing

Relation Back

Adjustment

The Taxpayer must notify the IRS

of the FTR Event by filing an

amended return, which includes

an amended Form 1118 or Form

1116. Additionally, the Taxpayer

must provide the IRS with a reg.

section 1.905-4T(c) notification

statement for the tax year with

respect to which a

redetermination of U.S. tax

liability is required.

A statement containing the

Taxpayers name, address, EIN, and

taxable year(s) affected. The

statement must also include

sufficient information for the IRS to

redetermine the U.S. tax liability

including the date of accrual and

payment (and the date of refund, if

applicable), and exchange rates on

the relevant dates. Must include a

signed penalties of perjury

declaration. See Treas. Reg.

Section 1.905-4T(c)(1).

Reductions of FTC -

generally by due date (with

extension) of tax return for

the year of the FTR Event.

Increases of FTC – by the

end of the 10-year FTC

statute of limitations.

Special rules for multiple

redeterminations. See

Treas. Reg. section 1.905-

4T(b)(1).

Pool

Adjustment

The Taxpayer must notify the IRS

of the FTR Event by adjusting the

foreign corporation’s E&P and

FTC pools on Form 1118.

N/A Generally by due date

(with extension) of tax

return for the first tax year

affected by the FTR Event.

Special rules for Taxpayers under the Large and Mid-Size Business Division.

Additionally, separate rules for FTR Events from 2005-2007 and prior to 2005.


E&P Adjustments (Indirect Credits)

94

• As noted previously, adjustments must also be made to the E&P pool.

For example, a decrease in the foreign taxes paid will increase the E&P

pool.

• If Relation Back Adjustment is required for Indirect Credits,

consideration must be given as to other years that may be impacted

(e.g., years between the FTR Event and the year impacted).

• Allocation of refunds of foreign taxes shall be allocated to the same

Section 904 categories as the original expense.

Pooling and Relation Back Adjustment


Other Considerations

95

• Foreign Tax Redetermination After Sale of Stock

• Liquidations, Section 338 Elections, and other transactions

• If a foreign tax redetermination results in a redetermination of U.S. tax

liability, interest is computed on the deficiency or overpayment in

accordance with Section 6601 and Section 6611. However, if the

redetermination is the result of a refund of foreign tax and the foreign

government does not pay interest on the overpayment, no interest is

assessed for U.S. purposes for the period before the date of the refund.

Redetermination Event


Other Considerations

96

• If a taxpayer fails to notify the IRS of a FTR Event, Section 6689

imposes a penalty of 5 percent of the deficiency attributable to the

redetermination. The penalty increases an additional 5 percent for each

month (or partial month) during which the failure continues, subject to

a maximum penalty of 25 percent. Reasonable cause relief is available.

• If a Relation Back Adjustment is otherwise required, but the deficiency

is eliminated due to a FTC carryover or carryback, the taxpayer may

notify the IRS on the original return filed for the year of the FTR

Event, as opposed to amending prior returns.

Redetermination Event


Special Treaty

Provisions


Foreign Tax Credit Treaty Provisions Relief from Double Taxation

98

• Many U.S. income tax treaties, and the 1981 and 2006 U.S. Model

Treaty, contains a provision intended to mitigate double taxation to the

extent that relief is not otherwise provided under other treaty articles.

• In general, double taxation is avoided through a credit mechanism

where one State grants to its resident taxpayers a tax credit for any

income taxes paid to or imposed by the other State on income derived

in such other State.

• U.S. federal tax law generally already allows U.S. Taxpayers to claim a

foreign tax credit for taxes imposed by a foreign jurisdiction on income

derived from foreign sources.


Foreign Tax Credit Treaty Provisions Relief from Double Taxation

99

• Although the treaty provision is generally an extension of the U.S.

federal foreign tax credit mechanism, it does assist the Taxpayer by

providing that "Taxes Covered" are creditable for U.S. income tax

purposes.

• Absent such a treaty provision, a more detailed analysis often may be

required to determine if the foreign taxes in question are creditable

under U.S. federal tax law. However, such a treaty provision generally

may override the general Code and regulations requirements regarding

what constitutes a creditable tax.

• "Taxes Covered" generally also includes language extending the taxes

covered to any identical or substantially similar taxes which are imposed

after the date of signature of the treaty in addition to, or in place of,

the existing taxes.


Creditable Taxes Taxes that Otherwise May Not Be Considered Income Taxes

100

• Certain treaties provide relief from double taxation article to U.S.

taxpayers with a foreign tax credit for taxes of a type that might not be

considered to meet the requirements for creditable taxes under the

rules provided in the Internal Revenue Code (and as previously

discussed).

• For example, certain treaties (e.g., UK, Norway, Netherlands) provide

that certain oil and gas extraction taxes may be allowed as a credit if

certain requirements are satisfied under the treaty.


Sourcing Rules Resourcing – Foreign Source Income

101

• Some tax treaties affect the foreign tax credits that can be used by U.S.

persons by modifying the source rules of the Code (In other words,

potentially increasing the amount of a U.S. Taxpayer's foreign-source

income) for purposes of determining the applicable foreign tax credit

limitations under Section 904 and Section 907.

• Re-sourcing rules under Section 904(h) require specific sourcing rules

in cases of United States owned foreign corporations. However,

Section 904(h)(10) provides that the re-sourcing rule in a treaty takes

precedence over those included in Section 904(h).

• Taxpayer may elect to treat an item of interest income or certain other

types of income that would otherwise be treated as U.S. source income

under Section 904(h) as foreign source income, if such income would

be treated as foreign source income under a U.S. income tax treaty.


Sourcing Rules Resourcing – Foreign Source Income

102

• If such an election is made under Section 904(h)(10), Taxpayer must

apply certain Sections of 904, 902, 907, and 960 to the applicable item

of income re-sourced under the treaty.

• Generally speaking, this means Taxpayer is subjecting the income to

separate country and category basket limitations, which prevents the

Taxpayer from using excess FTCs in other categories.


Competent Authority Compulsory vs. Voluntary Payments

103

• As discussed previously, Taxpayers must exhaust all "effective and

practical" procedural remedies for the foreign taxes to be considered

compulsory (a requirement of creditability).

• Exhausting such procedural requirements includes Competent

Authority procedures provided under applicable tax treaties.

• The Taxpayer generally may be required to file a refund claim and

invoke the Competent Authority procedures under an applicable tax

treaty. See Rev. Rul. 76-508, Rev. Rul. 92-75 and Treas. Reg. Section

1.901-2(e)(5)(i).

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This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any

person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax advisor to discuss the potential application to your

particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed

herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not

intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue

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Documents

Foreign Tax Credit Utilization for Corporations: Calculations