Mastering Foreign Tax Credits for Corporations and Individuals: Calculations, Carrybacks, Carryforwards and Limitations

Mastering Foreign Tax Credits for Corporations and Individuals: Calculations, Carrybacks, Carryforwards and Limitations FOR LIVE PROGRAM ONLY WEDNESDAY, SEPTEMBER 7, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

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Mastering Foreign Tax Credits for Corporations and Individuals Sept. 7, 2016 Morris N. Robinson, Esq., CPA, LL.M., Managing Director M. Robinson & Co., Boston morris.robinson@mrobinson.com Patricia Weisgerber, Esq., LL.M. M. Robinson & Co., Boston patricia.weisgerber@mrobinson.com Alison N. Dougherty, J.D., LL.M., Senior Manager Aronson, Rockville, Md. adougherty@aronsonllc.com

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.

Foreign Tax Credit Structure: General Overview Purpose of General Overview 1. To present the conceptual framework. 2. To provide, in conceptual format, a listing of relevant sections of the Internal Revenue Code. 6

Foreign Tax Credit Structure: General Overview Objective of Foreign Tax Credit 1. Overall objective: Avoidance of double taxation by United States and a foreign country on identical foreign source income. 2. A Taxpayer may choose to take a deduction instead of a credit. IRC Sections 164 and 275(a)(4). 7

Foreign Tax Credit Structure: General Overview What Is Foreign Source Income? Five Key Internal Revenue Code Sections 1. Income from United States Sources Section 861 2. Income from Sources Outside the United States Section 862 3. Sourcing of Income Not Included in Sections 861 and 862 Section 863 4. Sourcing of Income from the Sale of Personal Property Section 865 5. Income Re-sourced by Treaty Section Section 904(d)(6) 8

Foreign Tax Credit Structure: General Overview Which Types of Foreign Source Income Are Creditable? 1. Realized Gross Income Section 61 2. Certain Categories of Imputed Income PFIC Inclusions Section 1291(g) PFIC Qualified Electing Funds Section 1293(f) Subpart F Income Section 960 Income reported under Sections 951 or 954 9

Foreign Tax Credit Structure: General Overview What Types of Foreign Taxes Are Creditable? 1. The foreign tax must tax income Section 901 2. Check guidance from IRS and U.S. Treasury. 3. Foreign tax credit applies to taxes, not interest and/or penalties. 10

Foreign Tax Credit Structure: General Overview Who Can Claim the Credit? The Taxpayer who reports the foreign source income claims the credit. This includes the following: 1. Individuals 2. Partners in Partnership Sections 702(a)(6) and 901(b)(5) 3. Shareholders of S Corporations Section 1373(a) 4. Estates and Trusts/Beneficiaries Sections 642(a) and 901(b)(5) 5. Recipient s of Income in Respect of Decedent Section 691(b) 11

Foreign Tax Credit Structure: General Overview Who Can Claim the Credit? Continued 6. Non-Resident Individuals Sections 874(c) and 906 7. Foreign Organizations Sections 882(c)(3) and 906 8. Exempt Organizations/Unrelated Business Income(UBTI) Section 515 12

Foreign Tax Credit Structure: General Overview Required Adjustment to the Foreign Tax Credit Exempt Income 1. Income of U.S. Citizens and Residents Living Abroad Section 911(d)(6)Foreign Organizations Sections 882(c)(3) 2. The foreign tax credit is NOT allowed on the portion of income excluded under Section 911. 1. Why? Because, if income is excluded from United States taxation, a double tax of that income by the United States and a foreign country cannot occur. 13

Foreign Tax Credit Structure: General Overview Required Adjustment to the Foreign Tax Credit Corporations Only 1. Dividend Gross-Up Section 78 Foreign taxes paid by a domestic parent corporation are treated as additional dividends to the domestic parent. 2. Deemed Dividends from 10 Percent-Owned Foreign Corporation Sections 245 and 902 3. These gross-up rules only apply to corporations. 14

Foreign Tax Credit Structure: General Overview Related Parties Suspension of Credit/Deduction 1. Generally, a Taxpayer may not deduct a foreign tax or claim a foreign tax credit on foreign income taxes paid if a related Taxpayer reports the income. See Section 909. 2. The regulations to Section 909 describe four types of transactions involving related parties where the foreign tax credit/deduction is suspended. 15

Foreign Tax Credit Structure: General Overview Substantiation 1. Foreign tax credits must be substantiated Section 905(b) 16

Foreign Tax Credit Structure: General Overview Conversion of Foreign Taxes from Foreign Currency to U.S. Currency 1. Generally, foreign taxes are converted at the spot exchange rate at the time paid. 2. Generally, accrued foreign taxes may be converted at the average exchange rate for the year Section 986 17

Foreign Tax Credit Structure: General Overview Denial of Foreign Tax Credit Certain Countries 1. Income taxes paid to certain countries are not creditable. See Section 901(j) and Rev. Rul. 95-63. 18

Foreign Tax Credit Structure: General Overview Netting Capital Gains and Losses 1. Capital losses are netted against capital gains in computing the foreign source capital gains and losses. 19

Foreign Tax Credit Structure: General Overview Redetermination of the Foreign Tax Credit 1. Reasons for Redeterminations Section 905(c) 1. Tax Refunds 2. Additional Assessments 3. Late Payment of Accrued Foreign Taxes 2. Requirement to Notify the IRS Section 905(c) and Treas. Reg. 1.905-3 3. Penalty for Failure to Notify the IRS: Up to 25% of Deficiency Section 6689 20

Foreign Tax Credit Structure: General Overview Statute of Limitations 1. Deficiency Arising from Foreign Tax Credit Carryback: One Year Section 6501(i) 2. The Statute of Limitations for Refunds Is Generally 10 Years Section 6511(d)(3) 21

Foreign Tax Credit Structure: Who Can Claim the Credit? The General Rule 1. The Taxpayer that reports the foreign source income claims the credit. 2. This is in keeping with the overall conceptual goal of avoiding double taxation by the United States and a foreign government on the identical foreign source income. 3. The application of these rules to various types of taxpayers follows. 23

Foreign Tax Credit Structure: Who Can Claim the Credit? Individuals 1. Individuals may elect to take the foreign tax credit or may deduct the foreign taxes. 2. There are special rules for taxpayers who are non-residents. 3. There are special rules for: Partners in a partnership S corporation shareholders Beneficiaries of trusts and estates, and Recipients of income in respect of decedent. 4. Some of these special rules are described below. 24

Foreign Tax Credit Structure: Who Can Claim the Credit? Resident Aliens 1. Resident aliens are treated like U.S. citizens. See the above slide. 2. Resident aliens are treated like U.S. citizens with respect to their foreign source income earned when they are residents of the United States. 3. There are also special rules for individuals who are nonresident aliens who have foreign source income that is subject to United States income taxes. 25

Foreign Tax Credit Structure: Who Can Claim the Credit? Partners in Partnerships 1. Partnerships are not subject to tax. Section 701. The income of a partnership is generally computed in the same manner as an individual. Section 703. 2. Resident aliens are treated like U.S. citizens with respect to their foreign source income earned when they are residents of the United States. 3. There are also special rules for individuals who are nonresident aliens who have foreign source income that is subject to United States income taxes. 26

Foreign Tax Credit Structure: Who Can Claim the Credit? Partners in Partnerships 1. Partnerships are not subject to tax. Section 701. The income of a partnership is generally computed in the same manner as an individual. Section 703. 2. United States partners are subject to tax on their distributive share of the partnership s foreign income, which must be separately listed on each partner s Form 1065 K-1. Section 702(a)(6). 27

Foreign Tax Credit Structure: Who Can Claim the Credit? Partners in Partnerships cont. 3. Each partner s proportionate share is allocated to him or her. Section 901(b)(5). 4. These allocations must be consistent with: 1) The partnership agreement Section 704(a) 2) The Treasury Regulations to Section 901(b)(5) 3) Economic reality the partnership regulations. Generally, the partner who receives the economic benefit from the foreign income is allocated the foreign income earned by the partnership. The foreign income taxes paid by the partnership and arising from the foreign income are allocated to the partners. 28

Foreign Tax Credit Structure: Who Can Claim the Credit? S Corporations and Their Shareholders 1. S corporations are treated as partnerships; and 2. The shareholders of such corporation are treated as partners of such partnership. Section 1373. 3. Partnerships are not subject to so-called built-in gains. Therefore, foreign income taxes arising from the built in gains of S corporations are not creditable. 29

Foreign Tax Credit Structure: Who Can Claim the Credit? Estates and Trusts/Beneficiaries Sections 642(a) and 901(b)(5) 1. The income of estates and trusts are generally subject to taxation as if they were individuals, Section 641(b). 2. The United States incomes taxes arising from income earned by estates and trusts (fiduciaries) are either taxed to the fiduciary or to the beneficiary to whom the fiduciary s income is distributed. 30

Foreign Tax Credit Structure: Who Can Claim the Credit? Estates and Trusts/Beneficiaries cont. 4. If the foreign income is not distributed, the fiduciary is subject to tax on the foreign income. The fiduciary may claim the foreign taxes paid by the fiduciary on that income. 5. If the income is distributed to the beneficiary, the beneficiary is subject to that foreign income. 6. For details, see Treasury Regulations to Section 901(b)(5). 31

Foreign Tax Credit Structure: Who Can Claim the Credit? Recipients of Income in Respect of Decedent - Section 691(b) 1. Income in Respect of Decedent ( IRD ) is income that the decedent should have reported as income had he or she survived to receive it. Section 691(a)(1). 2. IRD has the same character in the hands of the recipient that it would have had in the hands of the decedent. Section 691(a)(3). 3. The recipient may elect to deduct or credit the foreign taxes associated with the foreign income of the decedent. Section 691(b). 32

Foreign Tax Credit Structure: Who Can Claim the Credit? Non-Resident Individuals Sections 874(c) and 906 1. Non-resident individuals are subject to United States taxation on income effectively connected with the conduct of a trade or business within the geographical boundaries of the United States. Section 872. 2. Non-resident individuals are permitted to credit foreign income taxes assessed against that income. Section 906. 3. Non-resident individuals are NOT permitted to credit foreign income taxes assessed against fixed, determinable, annual, or periodic income that is not effectively connected with the conduct of a United States trade or business. Sections 874(c) and 906. 33

Foreign Tax Credit Structure: Who Can Claim the Credit? Foreign Corporations Section 882(c)(3) and 906 1. A similar rule applies to foreign corporations. See the above slide. 34

Foreign Tax Credit Structure: Who Can Claim the Credit? Exempt Organizations: Unrelated Business Income Section 515 1. Tax exempt organizations are subject to tax on their unrelated business taxable income. Section 511. 2. If the unrelated taxable income of a tax exempt organization includes foreign source income, these tax exempt organizations can take advantage of the United States foreign tax credit. 35

Foreign Tax Credits: Coordination with the Foreign Earned Income Exclusion and the Foreign Housing Exclusion Under Section 911 Attorney Morris N. Robinson, CPA. LLM morris.robinson@mrobinson.com All Rights Reserved.

Foreign Tax Credit Structure: Coordination with Section 911 Coordination with Section 911 1. Foreign taxes are NOT creditable if allocable to foreign income excluded under the foreign earned income credit or the foreign housing allowance. Section 911(b)(6). 2. These non-creditable foreign taxes are disallowed on Form 1116, Part III, Line 12. 3. If only a portion for the foreign source income is excluded, a proration of the foreign taxes is made. See instructions to Form 1116, Part III, Line 12. 37

Foreign Tax Credit Structure: Special Rules for Individuals and Corporations Individuals 1. Only individuals are entitled to the foreign earned income exclusion and the foreign housing allowance. 2. Only individuals must adjust the amount of their creditable foreign taxes by the taxes allocated to their foreign earned income exclusion and their foreign housing allowance exclusion. 3. The adjustment is made on Form 1116, Part III, Line 12. 39

Foreign Tax Credit Structure: Special Rules for Individuals and Corporations Corporations 1. Only corporations are required to gross-up their dividends (and deemed dividends) from the foreign corporations by the foreign income taxes associated with those dividends. 2. These adjustments are reflected on Form 1118, Part A, Column 2 (Deemed Dividends) and Column 3 (Other Dividends). 40

Foreign Tax Credit: Elements of the FTC Calculation Foreign Tax Credit Limitation Formula Section 904 Max. FTC = U.S. Tax x Foreign Source Taxable Income Worldwide Taxable Income The FTC limit is applied to each category of income. 42

Foreign Tax Credit: Elements of the FTC Calculation Foreign Source Income 1. Income from Sources without the United States Section 862(a) 1. Interest and dividends 2. Personal services compensation 3. Rents and royalties 4. Gains, profits and income 1. From the sale or exchange of real property 2. Derived from the purchase of inventory 5. Underwriting income 6. Amounts received from a foreign person for the provision of guarantee of indebtedness 43

Foreign Tax Credit: Elements of the FTC Calculation Foreign Source Income cont. 1. Gross income less expenses, losses and other apportioned or allocated deductions Section 862(b) 2. Special Rules for determining source of income Section 863 1. Secretary to allocate source when not otherwise specified. 3. Sections 861 through 863 are not intended to be all inclusive and the courts will determine source through comparison and analogy. 1. Look to substance of transaction 2. Look at where transaction occurred 44

Foreign Tax Credit: Elements of the FTC Calculation Foreign Source Income cont. Controlled Foreign Corporation Subpart F Income Section 952 1. Insurance income Section 953 2. Foreign base company income Section 954 3. Income subject to international boycott Section 999 4. Illegal bribes, kickbacks and other payments Section 952(a)(4) 5. Income derived from activities in sanctioned/901(j) countries 45

Foreign Tax Credit: Elements of the FTC Calculation Creditable Taxes 1. Foreign Income Tax 2. Compulsory Payment No Specific Economic Benefit 3. Tax on Income Income Not VAT or GST War Profits Excess Profits 4. Paid or Accrued 46

Foreign Tax Credit: Elements of the FTC Calculation Creditable Taxes Predominant Character Test Treas. Reg. 1.901-2(a)(1)(ii) and (3)(i) 1. Realization Treas. Reg. 1.901-2(b)(2) 2. Gross receipts Treas. Reg. 1.901-2(b)(3) 3. Net Income Treas. Reg. 1.901-2(b)(4) likely to reach net gain PPL Corp. & Subsidiaries v. Commissioner, 135 T.C. 304 (2010) U.K. windfall tax on excess profits No soak-up or taxes designed to tax U.S. residents or citizens only to the extent each $1 of foreign tax reduces U.S. tax liability by $1 Treas. Reg. 1.901-2(c) 47

Foreign Tax Credit: Elements of the FTC Calculation Creditable Taxes In-Lieu-Of Tax Section 903 1. General income tax is not imposed, but in-lieu-of tax is imposed instead Treas. Reg. 1.903-1(a) Must act as a substitute for as opposed to an additional tax 2. In-Lieu-Of Tax Requirements: Must be an income tax See Treas. Reg. 1.901-2(a)(2) Must meet the substitution requirements of Treas. Reg. 1.903-1(a)(1) Must NOT be a soak-up tax 48

Foreign Tax Credit: Elements of the FTC Calculation Creditable Taxes Directly Paid Foreign Taxes Section 901 & 903 Foreign Branches of Corporations Disregarded Entities Indirectly Paid Foreign Taxes Sections 902 & 960 Foreign Subsidiary of Corporation Sub-Part F Income Dividend Distributions 49

Foreign Tax Credit: Elements of the FTC Calculation Creditable Taxes Deemed Paid Tax Sections 902 and 960 1. When a domestic corporation owns 10 percent or more of the voting stock of a foreign corporation from which it receives dividends Section 902(a) 2. Amount of creditable tax is determined in proportion to the dividends received. The dividend amount of dividends is without regard to the Section 78 gross-up. 3. Deemed paid or accrued. 50

Foreign Tax Credit: Elements of the FTC Calculation Creditable Taxes - Section 78 Gross-up Example Domestic corporations claiming the FTC under Sections 902 and 960 must gross-up the amount of the dividend received by the proportional amount of taxes deemed paid See Treas. Reg. 1.960-3(a) U.S. Corp. CFC $80 Dividend CFC Profits before Tax $1,000 CFC Taxes $200 Post-1986 E & P $800 $80 (10%) Post-1986 Taxes $200 $20 (10%) Section 78 Grossed-up Dividend $100 51

Foreign Tax Credit: Elements of the FTC Calculation The FTC Limit - Income Categories: 1. Passive Category Income Section 904(d)(1)(A) 2. General Category Income Section 904(d)(1)(B) 3. Section 901(j) Income 4. Income Re-sourced by Treaty 5. Lump Sum Distributions Individuals Only 52

FTC Baskets FTC Baskets Passive Dividends Interest Rents Royalties Annuities Certain Net Gains Section 1293 Income General Not Passive Category Income Active Business Income Wages Salaries Employee Overseas Allowances 53

Foreign Tax Credit: Elements of the FTC Calculation FTC Baskets Section 904 1. Prior to the American Jobs Creation Act of 2004, there had been nine baskets of income. 2. Passive category income includes passive income and specified passive income. 1. Specified passive income includes dividends from DISCs and certain distributions from Foreign Sales Corporations. 3. General category income is income other than passive income but includes certain types of income under the look-through rules of Section 904(d). 54

Foreign Tax Credit: Elements of the FTC Calculation Section 901(j) Income 1. Denial of FTC for countries the U.S. does not recognize, has severed diplomatic ties, does not conduct relations, or which provides support for acts of international terrorism. 2. No deduction either. 3. As of January 1, 1987 or 6 months from when a country is sanctioned. 4. Presidential waiver can permit credit. 5. See Revenue Ruling 2005-3. 1. Cuba removed as of December 21, 2015 per Rev. Rul. 2016-08. 55

Foreign Tax Credit: Elements of the FTC Calculation Income Re-sourced by Treaty Section 904 1. Purpose is to prevent taxpayers from inflating foreign tax credit limitation by routing U.S. source income through a foreign affiliate. Section 904(h). 2. Elect to apply the treaty so that the income will be treated as foreign source. Section 904(d)(6). 3. Compute a separate FTC limitation for each amount of resourced income from a treaty country. 56

Foreign Tax Credit: Elements of the FTC Calculation Lump-sum Distributions 1. For taxes paid on a foreign source lump-sum distribution from a pension plan. For individual taxpayers only. 2. U.S. taxes are determined using Form 4972. 3. Special worksheet is provided in the instructions for Form 1116 to determine the amount of the credit. 57

Foreign Tax Credit: Elements of the FTC Calculation Foreign Tax Credit Calculation Example U.S. Taxable Income $750 Foreign Source Income $250 Worldwide Taxable Income $1,000 U.S. Tax Liability (at a 35% tax rate (before the foreign tax credit) $350 Taxes levied by foreign country $75 Max. FTC = U.S. Tax x Foreign Source Taxable Income Worldwide Taxable Income $87.50= $350 x $250 $1000 The taxpayer s final tax liability is $275. 58

Mastering Foreign Tax Credits: Calculations, Carrybacks, Carryforwards and Limitations Alison N. Dougherty September 7, 2016 http://blogs.aronsonllc.com/tax/u-s-taxpayers-foreign-tax-credits/ 2015 2015 All Rights Reserved 805 King Farm Boulevard Suite 300 Rockville, Al 2016 All Rights Reserved 805 King Farm Boulevard Suite 300 Rockville, Maryland 20850 301.231.6200 P 301.231.7630 F www.aronsonllc.com

Deduction vs. Credit for Foreign Taxes 1. A deduction for foreign tax paid or accrued is a subtraction from income that decreases income that is otherwise subject to U.S. Federal tax. 2. A credit for foreign tax paid or accrued is a dollar for dollar offset against the U.S. Federal tax liability on the foreign source taxable income. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 61

Deduction vs. Credit for Foreign Taxes - U.S. Individuals Decision to claim deduction or credit applies to all qualified foreign taxes paid for a particular tax year Cannot claim both a deduction and credit in the same year for foreign income taxes paid Only foreign income taxes qualify for the foreign tax credit Foreign taxes that are not income taxes such as foreign real and personal property taxes are deductible even if a credit is claimed for foreign income taxes Deduct foreign taxes that are not income taxes only if they are trade or business expenses or related to production of income Individuals claim Schedule A itemized deduction for foreign taxes paid if not trade or business expense or for production of income Deduct foreign real property taxes as Schedule A itemized deduction if not trade or business expense or for production of income Foreign tax credit is generally better than the deduction Exception is when limitation prevents utilization of excess credits because there is not sufficient foreign source taxable income in carryback or carryforward years No foreign tax credit allowed for foreign tax paid on income excluded based on foreign earned income exclusion including the foreign housing cost exclusion 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 62

Deduction vs. Credit for Foreign Taxes - U.S. Individuals Why should individuals choose the credit? Foreign tax credit is a dollar for dollar reduction of U.S. Federal income tax liability on foreign source taxable income Foreign tax credit is not allowed to offset U.S. Federal tax liability on U.S. source taxable income Deduction of foreign tax only decreases income subject to U.S. Federal tax The foreign income tax deduction for individuals is Schedule A itemized deduction Individuals can choose to take the credit even if they do not claim Schedule A itemized deductions. The credit is allowed with the standard deduction. With the credit, foreign tax that exceeds the limit are first carried back one year and then carried forward 10 years. Individuals claim the foreign tax credit by filing Form 1116 with U.S. Federal Form 1040 individual income tax return. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 63

Deduction vs. Credit for Foreign Taxes - U.S. Individuals Why should individuals choose the credit? IRS Publication 514 Example For 2015, you and your spouse have adjusted gross income of $80,300, including $20,000 of dividend income from foreign sources. None of the dividends are qualified dividends. You file a joint return and can claim two $4,000 exemptions. You had to pay $1,900 in foreign income taxes on the dividend income. If you take the foreign taxes as an itemized deduction, your total itemized deductions are $15,000. Your taxable income then is $57,300 and your tax is $7,676. If you take the credit instead, your itemized deductions are only $13,100. Your taxable income then is $59,200 and your tax before the credit is $7,961. After the credit, however, your tax is only $6,061. Therefore, your tax is $1,615 lower ($7,676 $6,061) by taking the credit. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 64

Deduction vs. Credit for Foreign Taxes U.S. Individuals Making or changing the individual s choice between foreign tax deduction or credit Make or change the choice to claim a foreign tax deduction or credit at any time within 10 years from the original due date of the U.S. Federal Form 1040 individual income tax return (not including extensions) filed for the tax year in which the foreign tax was paid. Make or change the choice on the U.S. Federal Form 1040 individual income tax return (or on an amended return) for the year the choice is to be effective. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 65

Deduction vs. Credit for Foreign Taxes U.S. Individuals IRS Publication 514 FTC for Individuals - Example of Individual making or changing choice (Part I) You paid foreign taxes for the last 13 years and chose to deduct them on your U.S. income tax returns. You were timely in both filing your returns and paying your U.S. tax liability. In February 2015, you file an amended return for tax year 2004 choosing to take a credit for your 2004 foreign taxes because you now realize that the credit is more advantageous than the deduction for that year. Because the regular due date of your 2004 return was April 15, 2005, this choice is timely (within 10 years). 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 66

Deduction vs. Credit for Foreign Taxes U.S. Individuals IRS Publication 514 FTC for Individuals - Example of Individual making or changing choice (Part II) Because there is a limit on the credit for your 2004 foreign tax, you have unused 2004 foreign taxes. Ordinarily, you first carry back unused foreign taxes arising in 2004 to 2003, and claim them as a credit in, the preceding tax year. If you are unable to claim all of them in that year, you carry them forward to the 10 years following the year in which they arose. Because you originally chose to deduct your foreign taxes and the 10 year period for changing the choice for 2003 has passed, you cannot change your choice and carry the unused 2004 foreign taxes back to tax year 2003. Because the 10 year periods for changing the choice have not passed for your 2005 through 2014 income tax returns, you can still choose to claim the credit for those years and carry forward any unused 2004 foreign taxes. However, you must reduce the unused 2004 foreign taxes that you carry forward by the amount that would have been allowed as a carryback if you had timely carried back the foreign tax to tax year 2003. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 67

Deduction vs. Credit for Foreign Taxes U.S. Individuals Making or changing the choice for individuals 10 year limitations period applies for making election Limitations period for refund claims relating to foreign tax credit runs parallel with 10 year election period Limitations period for refund claims relating to the foreign tax deduction does not run parallel with 10 year election period and it may expire before the end of the election period. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 68

Deduction vs. Credit for Foreign Taxes U.S. Individuals 10 year limitations period applies to claims for refund or credit based on: Corrections for math errors in figuring qualified foreign taxes Reporting qualified foreign taxes not originally reported on the return, or Any other change in the amount of the credit (including one caused by correcting the foreign tax credit limit). 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 69

Deduction vs. Credit for Foreign Taxes CCA 201204008 IRS allows change from deduction to credit within 10 year period but change from credit to deduction must be made within three year statute of limitations period based on interpretation of I.R.C. Section 6511(d)(3). CCAs 201330031 and 201517005 IRS has followed its conclusion and rejected refund claims based on change from credit to deduction filed more than three years but less than 10 years after original due date of original tax return. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 70

Deduction vs. Credit for Foreign Taxes U.S. Corporations U.S. corporation may choose annually whether to claim deduction or credit for foreign taxes paid or accrued. If credit is claimed for the tax year then no portion of the foreign taxes will be allowed as a deduction in that year or any subsequent year. Credit is claimed by filing Form 1118 with U.S. Federal Form 1120 corporate income tax return. Deduction allowed for taxes ineligible for credit in the same tax year as credit for eligible taxes Certain taxes are not eligible for deduction or credit 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 71

Deduction vs. Credit for Foreign Taxes U.S. Corporations Foreign tax credit for U.S. corporations is a dollar for dollar offset against regular U.S. Federal corporate income tax liability Separate corporate AMT foreign tax credit is allowed subject to special AMT FTC limitation Generally better to claim credit than deduction Corporate foreign tax credit carryback one year and carryforward 10 years 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 72

Deduction vs. Credit for Foreign Taxes U.S. Corporations Examples of reasons why deduction would be preferable for a corporation When foreign source deductions exceed foreign source income for the year The limitation prevents utilization of excess credits when foreign branch operations are discontinued and there is not sufficient foreign source taxable income in first preceding year or subsequent 10 years. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 73

Limitations, Carrybacks, Carryovers and Recalculations Terminology Foreign tax credit limitation = the maximum amount of foreign tax credit that can be claimed in the current tax year Excess limitation = limitation is greater than foreign tax credit that can be claimed Excess credit = limitation is less than foreign taxes paid or accrued Foreign loss = deductions properly allocated and apportioned to foreign source income exceed foreign source income Domestic loss = deductions properly allocated and apportioned to U.S. source income exceed U.S. source income, determined without regard to loss carrybacks Overall foreign loss (OFL) = the excess of foreign source loss over foreign source income that offsets U.S. source income Overall domestic loss (ODL) = the excess of U.S. source loss over U.S. source income that offsets foreign source income Separate limitation loss (SLL) = a loss arising in one separate limitation category Separate limitation income (SLI) = foreign source taxable income computed for each income category as determined for the foreign tax credit limitation 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 74

Limitations, Carrybacks, Carryovers and Recalculations I.R.C. Section 904 Foreign Tax Credit Limitation = Foreign Source Taxable Income x U.S. Federal Tax Worldwide Taxable income Foreign tax credit allowed = the lesser of: (1) the foreign taxes paid or accrued (2) the amount of the foreign tax credit limitation 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 75

Limitations, Carrybacks, Carryovers and Recalculations Foreign tax credit limitation example: A is a U.S. citizen and has worldwide taxable income of $75,000 for the current year of which $25,000 is from foreign sources. A paid $10,000 of foreign tax on the foreign-source income. A s U.S. tax liability is $15,000 before the foreign tax credit. What is A s foreign tax credit limitation? $25,000/$75,000 x $15,000 = $5,000 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 76

Limitations, Carrybacks, Carryovers and Recalculations Foreign tax credit limitation is a function of the proportionate amount of foreign source taxable income to worldwide taxable income Determine foreign source gross income based on U.S. sourcing rules Allocate and apportion expenses to foreign source income Foreign source taxable income = 1. foreign source gross income less 2. directly allocable and indirectly apportioned expenses 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 77

Limitations, Carrybacks, Carryovers and Recalculations To determine the foreign tax credit limitation, separate foreign source income into categories, i.e., baskets of income to prevent maximizing foreign tax credit by blending income subject to higher foreign tax rate with income subject to lower foreign tax rate. Separate Limit Income - Must calculate the limit separately for each of the following categories of income. In figuring the separate limits, combine the income (and losses) in each category from all foreign sources and then apply the limit. 1. Passive category income including high taxed income 2. General category income 3. Section 901(j) income from activities in sanctioned countries 4. Certain income re-sourced by treaty 5. Any lump-sum distribution from an employer benefit plan for which the special averaging treatment is used to determine the tax FTC limit = Foreign source taxable income in separate basket Worldwide taxable income x U.S. Federal tax (before foreign tax credit) 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 78

Limitations, Carrybacks, Carryovers and Recalculations Foreign Losses - If there is a foreign loss when figuring your taxable income in a separate limit income category and there is income in one or more of the other separate categories, first reduce the income in these other categories by the loss before reducing income from U.S. sources. See IRS Publication 514. The amount of your taxable income (or loss) in a separate category is determined after any adjustments you make to your foreign source qualified dividends or your foreign source capital gains (losses). Example There is $10,000 of passive category income and a loss of $5,000 in the general category income basket. You must use the $5,000 loss to offset $5,000 of passive category income. How to allocate You must allocate foreign losses among the separate limit income categories in the same proportion as each category's income bears to total foreign source income. Example There is a $2,000 loss that is general category income, $3,000 of passive category income, and $2,000 of income re-sourced by treaty. You must allocate the $2,000 loss to the income in the other separate categories. 60% ($3,000/$5,000) of the $2,000 loss (or $1,200) reduces passive category income and 40% ($2,000/$5,000) or $800 reduces the income re-sourced by treaty. Loss more than foreign income - If you have a loss remaining after reducing the income in other separate limit categories, use the remaining loss to reduce U.S. source income. For this purpose, the amount of your U.S. source income is your taxable income from U.S. sources increased by the amount of capital losses from U.S. sources that reduced foreign source capital gains as part of a U.S. capital loss adjustment. When you use a foreign loss to offset U.S. source income, you must recapture the loss. U.S. Losses - Allocate any net loss from sources in the United States among the different categories of foreign income after allocating all foreign losses as described earlier, and before any adjustments. The amount of your net loss from sources in the United States is equal to the excess of (1) your foreign source taxable income in all of your separate categories in the aggregate, after taking into account any adjustments for qualified dividends and adjustments to foreign source capital gains and losses over (2) the amount of taxable income you enter on Form 1116, line 18. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 79

Limitations, Carrybacks, Carryovers and Recalculations Recapture of Prior Year Overall Foreign Loss (OFL) Accounts Overall foreign loss (OFL) - You have an overall foreign loss if your gross income from foreign sources for a tax year is less than the sum of your expenses, losses, or other deductions that you allocated and apportioned to foreign income under the rules explained. If you have only losses in your separate limit categories, or if you have a loss remaining after allocating your foreign losses to other separate categories, you have an overall foreign loss. If you use this loss to offset U.S. source income (resulting in a reduction of your U.S. tax liability), you must recapture your loss in each succeeding year in which you have taxable income from foreign sources in the same separate limit category. You must recapture the overall loss regardless of whether you chose to claim the foreign tax credit for the loss year. You recapture the loss by treating part of your taxable income from foreign sources in a later year as U.S. source income. In addition, if, in a later year, you sell or otherwise dispose of property used in your foreign trade or business, you may have to recognize gain and treat it as U.S. source income, even if the disposition would otherwise be nontaxable. The amount you treat as U.S. source income reduces the foreign source income, and therefore reduces the foreign tax credit limit. You must establish separate accounts for each type of foreign loss that you sustain. The balances in these accounts are the overall foreign loss subject to recapture. Reduce these balances at the end of each tax year by the loss that you recaptured. You must attach a statement to your Form 1116 or Form 1118 to report the balances (if any) in your overall foreign loss accounts. See IRS Publication 514. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 80

Limitations, Carrybacks, Carryovers and Recalculations OFL Recapture - If you have an overall foreign loss for any tax year and use the loss to offset U.S. source income, part of your foreign source taxable income (in the same separate limit category as the loss) for each succeeding year is treated as U.S. source taxable income. The part that is treated as U.S. source taxable income is the smaller of the following. 1. The total amount of maximum potential recapture in all overall foreign loss accounts. The maximum potential recapture in any account for a category is the lesser of: a. The current year taxable income from foreign sources in that category (the amount from Form 1116, line 15, less any adjustment for allocation of foreign losses and U.S. losses for that category, discussed earlier); or b. The balance in the overall foreign loss account for that category. 2. 50% (or more, if you choose) of your total taxable income from foreign sources. Deduction for foreign taxes - You must recapture part (or all, if applicable) of an overall foreign loss in tax years in which you deduct, rather than credit, your foreign taxes. You recapture the lesser of: 1. The balance in the applicable overall foreign loss account, or 2. The foreign source taxable income of the same separate limit category that resulted in the overall foreign loss minus the foreign taxes imposed on that income. See IRS Publication 514. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 81

Limitations, Carrybacks, Carryovers and Recalculations Recapture of Separate Limitation Loss Accounts - If in a prior tax year, you reduced your foreign taxable income in the separate limit category by a pro rata share of a loss from another category, you must recharacterize in the current year all or part of any income you receive in the current year in that loss category. If you have separate limitation loss accounts in the loss category relating to more than one other category and the total balances in those loss accounts exceed the income you receive in the current year in the loss category, then income in the loss category is recharacterized as income in those other categories in proportion to the balances of the separate limitation loss accounts for those other categories. You recharacterize the income by: 1. Increasing foreign taxable income (adjusted by certain adjustments) for each of the separate categories (other than the loss category) previously reduced by any separate limitation loss, and 2. Decreasing foreign taxable income (adjusted by certain adjustments) for the loss category by the amount of recharacterized income. See IRS Publication 514. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 82

Limitations, Carrybacks, Carryovers and Recalculations Recapture of Overall Domestic Loss Accounts - If you have an overall domestic loss for any tax year beginning after 2006, you create, or increase the balance in, an overall domestic loss account and you must recharacterize a portion of your U.S. source taxable income as foreign source taxable income in succeeding years for purposes of the foreign tax credit. The part that is treated as foreign source taxable income for the tax year is the smaller of: 1. The total balance in your overall domestic loss account in each separate category (less amounts recaptured in earlier years), or 2. 50% of your U.S. source taxable income for the tax year. You must establish and maintain separate overall domestic loss accounts for each separate category in which foreign source income is offset by the domestic loss. The balance in each overall domestic loss account is the amount of the overall domestic loss subject to recapture. The recharacterized income is allocated among and increases foreign source income in separate categories in proportion to the balances of the overall domestic loss accounts for those separate categories. See IRS Publication 514. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 83

Limitations, Carrybacks, Carryovers and Recalculations U.S. Treas. Reg. Section 1.904(g)-3 Ordering Rules 1. Allocate net operating losses and net capital loss carryovers 2. Make I.R.C. Section 904(b) adjustments 3. Allocate separate limitation losses 4. Allocate U.S. source losses 5. Recapture overall foreign losses 6. Recapture separate limitation losses 7. Recapture overall domestic losses 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 84

Limitations, Carrybacks, Carryovers and Recalculations Carryback and Carryover - If because of the limit on the credit, you cannot use the full amount of qualified foreign taxes paid or accrued in the tax year, you are allowed a 1-year carryback (not elective) and then a 10-year carryover of the unused foreign taxes. This means that you treat the unused foreign tax of a tax year as though the tax were paid or accrued in your first preceding and 10 succeeding tax years up to the amount of any excess limit in those years. A period of less than 12 months for which you make a return is considered a tax year. The unused foreign tax in each category is the amount by which the qualified taxes paid or accrued are more than the limit for that category. The excess limit in each category is the amount by which the limit is more than the qualified taxes paid or accrued for that category. Figure your carrybacks or carryovers separately for each separate limit income category. See IRS Publication 514. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 85

Limitations, Carrybacks, Carryovers and Recalculations Foreign Tax Redeterminations Must amend U.S. Federal income tax return if you claim a foreign tax credit and then receive a refund of the credited taxes in a later year Must reduce the credited taxes by the amount refunded Penalties apply for the failure to amend to adjust 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 86

Limitations, Carrybacks, Carryovers and Recalculations Foreign Tax Redetermination - A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed. The year in which to claim the credit remains the year to which the foreign taxes paid or accrued relate, even if the change in foreign tax liability occurs in a later year. If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required if any of the following conditions apply. 1. The accrued taxes when paid differ from the amounts claimed as a credit. 2. The accrued taxes you claimed as a credit in one tax year are not paid within 2 years after the end of that tax year. If this applies to you, you must reduce the credit previously claimed by the amount of the unpaid taxes. You will not be allowed a credit for the unpaid taxes until you pay them. When you pay the accrued taxes, a new foreign tax redetermination occurs and you must translate the taxes into U.S. dollars using the exchange rate as of the date they were paid. The foreign tax credit is allowed for the year to which the foreign tax relates. 3. The foreign taxes you paid are refunded in whole or in part. For taxes taken into account when accrued but translated into dollars on the date of payment, the dollar value of the accrued tax differs from the dollar value of the tax paid because of fluctuations in the exchange rate between the date of accrual and the date of payment. However, no redetermination is required if the change in foreign tax liability for each foreign country is solely attributable to exchange rate fluctuations and is less than the smaller of: 1. $10,000, or 2. 2% of the total dollar amount of the foreign tax initially accrued for that foreign country for the U.S. tax year. In this case, you must adjust your U.S. tax in the tax year in which the accrued foreign taxes are paid. See IRS Publication 514. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 87

ALISON N. DOUGHERTY SENIOR MANAGER ARONSON LLC Direct (301) 231-6290 Main (301) 231-6200 Email: adougherty@aronsonllc.com 805 King Farm Blvd, Third Floor Rockville, MD 20850 Washington, DC Metro Area Alison N. Dougherty provides tax services as a Senior Manager at Aronson LLC. Alison specializes in international tax reporting, compliance, consulting, planning and structuring as a subject matter leader of Aronson s international tax practice. She has extensive experience assisting clients with U.S. tax reporting and compliance for offshore assets and foreign accounts. She provides outbound U.S. international tax guidance to U.S. individuals and businesses with activities in other countries. She also provides inbound U.S. international tax guidance to nonresident individuals and businesses with activities in the United States. She has worked extensively in the area of U.S. international tax reporting and compliance with the preparation of the U.S. Federal Forms 5471, 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 and FBAR. She has counseled U.S. taxpayers regarding the outbound formation, capitalization, acquisition, operation, reorganization and liquidation of foreign companies. She has significant experience with U.S. Federal nonresident tax withholding, foreign partner tax withholding and FIRPTA withholding. She works closely with nonresident individuals and businesses regarding inbound U.S. real property investment. She often assists U.S. taxpayers with IRS amnesty program disclosures of offshore assets and foreign accounts. Alison completed the LL.M. (Master of Laws) in Securities and Financial Regulation in 2004 with academic distinction at Georgetown University Law Center. She completed the LL.M. (Master of Laws) in Taxation in 2000 and the Juris Doctor in 1999 at the University of Denver College of Law. She completed a Bachelor of Arts degree in Foreign Language in 1995 at Virginia Commonwealth University. 2016 All Rights Reserved Aronson LLC www.aronsonllc.com www.aronsonllc.com/blogs 88

Foreign Tax Credits: Form 1116 90

Foreign Tax Credits: Form 1116 Separate Categories of Income The Five Boxes (a through e) 1. A separate Form 1116 is prepared for the Five Boxes: 1) Passive category income 2) General category income 3) Section 901(j) income 4) Income resourced by treaty 5) Lump-sum distributions from pension plans 91

Foreign Tax Credits: Form 1116 Additional Forms 1116 1. Alternative Minimum Taxable Income. For the Five Boxes, see the above slide. 2. PFIC Income. separate Form 1116 is prepared for the Five Boxes: For the Five Boxes, see the above slide. 92

Foreign Tax Credits: Form 1116 Part I: Foreign Source Income 1. Part I, Line g: Foreign source income is listed by country where earned. 2. Part I, Line 2: Definitely related expenses. 3. Part I, Line 3: Prorated Expenses. 4. Part I, Line 3b: Prorated Itemized deductions. 93

Foreign Tax Credits: Form 1116 Part I: Foreign Taxes Paid or Accrued 1. Election box: Paid or Accrued 2. Date paid or accrued 3. Allocation of tax to type of income a. In foreign currency: columns (k), (l), (m), and (n) b. In United States dollars: columns (o), (p), (q), and (r) 94

Foreign Tax Credits: Form 1116 Creditable Taxes 1. Part III, Line 9: Taxes paid or accrued for the year. 2. Part III, Line 10: Carryback or carryforward of creditable foreign taxes to the year. 3. Part III, Line 12: Reduction in Foreign Taxes associated with foreign income excluded under Section 911. See earlier slide Individuals 95

Foreign Tax Credits: Form 1116 Computation of the Maximum Allowable Credit 1. Part III, Lines 15-21: Computation of the maximum allowable credit per foreign income category. See previous slides related to foreign income. 96

Foreign Tax Credits: Form 1116 Total Credit 1. Part IV, Line 27: The total credit that can be claimed in any taxable year. 2. Part IV, Lines 28-31: Special adjustments see instructions to Form 1116. 97

Foreign Tax Credits: Form 1118 99