There are three proven strategies for eliminating excess credits:
1. Foreign tax reduction planning,
2. Increasing the limitation, and
3. Cross-crediting.
Part I of this blog will cover the first two. Part II will cover the third, Cross-crediting.
A. Foreign Tax Reduction Planning
For U.S. persons in excess limitation positions, foreign tax reduction planning has no effect on their total tax costs. Why? Because any decrease in foreign tax is accompanied by an offsetting increase in the U.S. tax on foreign income.
For U.S. persons in excess credit positions, foreign taxes increase the total tax costs of such Taxpayers by the amount of the excess credits. As a consequence, every dollar of foreign income taxes saved reduces the taxpayer’s total tax costs by a dollar, up to the amount of excess credits.
Below are five techniques that a U.S. person can use to reduce foreign income taxes:
1. Seek incentives from a foreign country to build a plant.
i. Example: USAco wants to build a plant and hire a lot of employees. There’s nothing that gets a politician going more than a chance for more manufacturing jobs. USAco goes to foreign country and says, “We want to build a plant here but we want our tax rate lowered from 50% to 25%.” Will the foreign country go for it? They may. If not, USAco will play them off against another country to get the rate they want.
ii. Analysis: By negotiating a rate of tax that goes from a 50% down to 25%, USAco goes from an excess credit position to an excess limitation position.
2. Take advantage of any special exemptions, deductions, or credits;
3. Realize income in a form that is taxed at a lower rate (such as a preferential rate for capital gains);
4. Defer the recognition of gross income; and
5. Accelerate the recognition of deductions.
B. Increasing the Limitation
How can the foreign tax credit limitation be increased? There are two ways. First, by resourcing gross income in a way that increases the proportion of worldwide income that is classified as foreign-source income. And second, by recharacterizing deductions (reducing the apportionment of expenses to foreign source income).
1. Increasing the proportion of worldwide income that is classified as foreign-source income
i. The U.S. rules for sourcing gross income play a decisive role in reducing excess credits.
ii. Example: The title passage rule for sourcing income from inventory sales provides U.S. companies with a significant opportunity to increase foreign-source income. By arranging for the passage of title in a foreign country, export sales will generate foreign-source income.
2. Recharacterizing deductions
i. If a deduction is allocated to foreign-source income, it reduces the foreign tax credit limitation.
ii. As a result, a taxpayer in an excess credit position derives no net U.S. tax benefit from deductions allocated to foreign-source income.
iii. In contrast, deductions allocated to U.S.-source income do not affect the foreign tax credit limitation.
3. Example
1. Facts: USAco is a domestic corporation. It has $ 4 million of U.S.-source taxable income and $ 8 million of foreign-source taxable income that is subject to foreign income tax. Assume that the foreign income tax rate is 50% and the U.S. rate is 35%.
2. USAco has $ 1.2 million of excess credits, computed as follows:
a. Foreign income taxes
i. [$ 8 million x 50%]: $ 4 million
b. Foreign tax credit limitation
i. Worldwide taxable income: $ 12 million
ii. Pre-credit U.S. tax [$ 12 million x 35%]: $ 4.2 million
iii. Foreign-source taxable income: $ 8 million
iv. Limitation = Pre-credit U.S. tax x (Foreign-source taxable income/Worldwide taxable income)
v. Limitation = $ 4.2 million x ($ 8 million/$ 12 million) = $ 2.8 million
c. Excess foreign tax credit
i. The foreign tax credit is the lesser of:
1. FITs ($ 4.0 million), or
2. Limitation ($ 2.8 million)
ii. Analysis: Because the limitation of $ 2.8 million is less than the foreign income taxes of $ 4 million, the foreign tax credit is the limitation.
iii. USAco has $ 1.2 million of excess credits.
3. Assume that USAco can recharacterize $ 2 million of U.S.-source income as foreign-source income, but only for U.S. tax purposes. In other words, there is now $ 10 million of foreign-source taxable income even though only $ 8 million is subject to tax in the foreign country. Every dollar of resourced income increases USAco’s limitation and has no effect on USAco’s foreign taxes. The net effect is a reduction in USAco’s excess credits from $ 1.2 million to $ 500,000, computed as follows:
a. Foreign income taxes
i. [$ 8 million x 50%]: $ 4 million
b. Foreign tax credit limitation
i. Worldwide taxable income: $ 12 million. $ 2 million U.S. + $ 10 million foreign.
ii. Pre-credit U.S. tax [$ 12 million x 35%]: $ 4.2 million.
iii. Foreign-source taxable income: $ 10 million (because $ 2 million of U.S.-source income was resourced as foreign source income).
iv. Limitation = Pre-credit U.S. tax x (Foreign-source taxable income/Worldwide taxable income).
v. Limitation = $ 4.2 million x ($ 10 million/$ 12 million) = $ 3.5 million.
c. Excess foreign tax credit
i. The foreign tax credit is the lesser of:
1. FITs, or
2. Limitation
ii. Analysis: Because the limitation of $ 3.5 million is less than the foreign income taxes of $ 4 million, the foreign tax credit is the limitation.
iii. USAco has $ .5 million of excess credits.
4. On the other hand, if the resourcing of USAco’s income for U.S. tax purposes also increases USAco’s taxable income for foreign tax purposes, the $ 2 million of resourced income will increase USAco’s foreign income taxes at a faster rate than it will increase its limitation. The net effect will be an increase in USAco’s excess credits from $ 1.2 million to $ 1.5 million, computed as follows:
a. Foreign income taxes
i. [$ 10 million x 50%]: $ 5 million.
b. Foreign tax credit limitation
i. Worldwide taxable income: $ 12 million. $ 2 million U.S. + $ 10 million foreign.
ii. Pre-credit U.S. tax [$ 12 million x 35%]: $ 4.2 million.
iii. Foreign-source taxable income: $ 10 million (because $ 2 million of U.S.-source income was resourced as foreign source income).
iv. Limitation = Pre-credit U.S. tax x (Foreign-source taxable income/Worldwide taxable income).
v. Limitation = $ 4.2 million x ($ 10 million/$ 12 million) = $ 3.5 million.
c. Excess foreign tax credit
i. The foreign tax credit is the lesser of:
1. FITs, or
2. Limitation
ii. Analysis: Because the limitation of $ 3.5 million is less than the foreign income taxes of $ 5 million, the foreign tax credit is the limitation.
iii. USAco has $ 1.5 million of excess credits.