1 Open questions from last class Review homework Foreign tax credit (FTC) –How it works –Application of sourcing rules –Interaction with Sec 911 Agenda for Class 3

2 Need for Foreign Tax Credits US citizens and residents subject to US tax on worldwide income FTC eliminates double taxation by allowing a credit against US tax for foreign tax FTC limited to lesser of foreign tax or US tax on income Treaties also provide protection against double taxation

3 Foreign Tax Credit Income$100,000 (foreign source) US tax rate30% Foreign tax rate40% US tax$30,000 (a) Foreign tax$40,000 (b) Credit – Lesser of (a) or (b) $30,000

4 Foreign Tax Credit Credit (Sec 901(a)) vs. deduction (Sec 164(a)) Annual election Compulsory payment Not payment for economic benefit What happens if employer pays tax on behalf of employee?

5 Foreign Tax Credit “Foreign Tax” – tax on income or profit imposed by a foreign country Income tax in US sense Specific country guidance provided by IRS Some social taxes creditable, unless totalization agreement in force Wealth tax, church tax, fringe benefits tax usually not creditable “Any political subdivision of any foreign state” (g)(2)

6 FTC Baskets Taxable years beginning after 2007 –Passive income –General category income Taxable years beginning before 2007 –Passive income –High withholding tax interest –Financial services income –Shipping income –Dividends from DISC or former DISC –Distributions from FSC or former FSC –Lump sum distributions –Section 901(j) income – sanctioned countries –General limitation income Income resourced by treaties

7 IRC Sec 904(a) FTC allowed to the lesser of –Foreign tax available for credit (after disallowance) –Foreign tax credit limitation Foreign tax credit limitation - % of US tax generated by foreign source taxable income Foreign sourceUS income taxable incomeXtax before Total taxable incomecredits

8 Foreign Sourced Income - Expatriate Total PdUS Source Foreign Source Base salary - Pre - During $82,500 97,500 Bonus30,000 COLA25,000 Total$235,000

9 Sourcing Interest – source of payment of interest determines whether US or foreign source –§ 861(a)(1) and 862(a)(1) –§ 871(h) “Portfolio interest received by a NRA from sources within the US, no tax shall be imposed under [30% withholding tax]” Dividends – source of payment –§ 861(a)(2) and 862(a)(2) –Paid by domestic US corporation: US source –Paid by foreign corporation: foreign source –Mutual funds provide details of foreign source income 80/20 rule repealed

10 Sourcing What happens when US deems US source and foreign country taxes income? –1/1/2005 Joe was granted 10,000 $10 –1/1/2008 shares vest, FMV $15 –1/1/2009 Joe exercised 10,000 shares, FMV $17 –7/1/2007 Joe went on assignment to X Country –X Country taxes residents on worldwide income and taxes shares on exercise –Joe’s marginal tax rate in X Country is 50% What are the US tax consequences?

11 Sourcing What happens when US deems US source and foreign country taxes income? –9/1/2008 Grace moved to Country Y –3/3/2009 Grace received a bonus of $7,000 related to services performed in calendar year 2008 –Country Y taxes 100% of Grace’s bonus of $7,000 at a marginal tax rate of 40% What are the US tax consequences?

12 Foreign Source Taxable Income Foreign source income Less deductions specifically allocable –Rental expenses associated with rental property –State and local tax (directly allocable to US income if related to US source income) –§ 911 exclusion Reg § T(e)(12)(iv) charitable contributions specifically allocable to US source income

13 Foreign Source Taxable Income Less pro-rata deductions not directly allocable Gross foreign Total ratably Foreign source income X allocable = expenses/ Total grossdeductions deductions income Less qualified resident interest T(d)(1)(iv) Gross foreign income lessForeign excluded income X Qual residence = source Gross income interestdeduction less excluded income

14 Limitation IRC Sec 904(a) FTC allowed to the lesser of –Foreign tax available for credit (after disallowance) –Foreign tax credit limitation Foreign tax credit limitation - % of US tax liability generated by foreign source taxable income Foreign source taxable income X US tax before credits Total taxable income Separate FTC limitations for different types of income

15 Disallowance/Scaledown/Kickout/Reduction Can’t claim 911 exclusion and FTC per § 911(d)(6) Foreign taxes disallowed to extent attributed to excluded income Foreign tax paidNet 911 exclusion or accrued duringXNet foreign earned taxable yearincome

16 Disallowance/Scaledown/Kickout/Reduction Net Sec 911 exclusion includes –Housing and foreign earned income exclusions –Less disallowed expenses relating to excluded income (e.g., employee business expenses) Net foreign earned income includes –Total foreign earned income –Less expenses relating to excluded income –US source income on which foreign tax is imposed (e.g., US workday income) –Amounts deductible on US return but are subject to tax in the foreign country (e.g., 401(k) contributions)

17 Process Step 1 – allocate foreign assignment compensation into US and foreign components Step 2 – calculate 911 exclusion –Determine number of qualifying days in year –Calculate housing exclusion –Calculate maximum allowable foreign earned income exclusion –Calculate actual foreign earned income exclusion Step 3 – scale-down any expenses related to excluded income (e.g., employee business expenses)

18 Process Step 4 – calculate disallowed foreign taxes Foreign tax paidNet 911 exclusion or accrued duringXNet foreign earned taxable yearincome Step 5 – calculate the foreign taxes available for credit or deduction Total Foreign taxes paid/accrued Less Disallowed from Step 4 Equals Foreign tax available for credit/deduction

19 Process Must be calculated for each year If taxpayer on “paid” basis and paid several years’ taxes in one year, calculate different scaledown ratios for exclusion for each year

20 Paid or Accrued Method Paid basis –Foreign taxes actually paid during the year –Regardless of the year to which the taxes relate Accrued basis –Total estimated/actual foreign tax liability for that tax year regardless of whether paid or settled during the year –Fiscal year end jurisdictions taken on US return in year in which foreign tax year ends –Example: UK tax year ends April 5 HK tax year ends March 31 Australia tax year ends June 30

21 Paid or Accrued Method Elect to take as paid or accrued Election is made by checking box on Form 1116 –Paid method may be changed in subsequent year to accrued method –Accrued method may be changed with consent of IRS Commissioner –In practice, can’t switch to paid method Documentation must be available upon request

22 Exchange Rate Paid method –Exchange rate in effect on day tax paid or withheld –Tax refund uses conversion rate on date tax paid Accrual method –Average exchange rate for the year –Use exchange rate on date of payment If paid more than 2 years after the close of the tax year If paid in the prior year

23 Redetermining FTC Paid method – if receive refund in later year, must file amended tax return reducing the tax credited by the amount refunded Accrued method –Accrued taxes when paid differs from amount claimed as a credit –Amount not paid within 2 years after close of tax year (utilize exchange rate on date of payment) –After accrued taxes paid, received refund of tax Practical approach – change FTC carry forward

24 FTC Carrybacks and Carryovers Unused credit can be carried back and carried forward New law –Applicable to credits generated in 2005 –Back 1 year –Forward 10 years –Credits generated 1999 or later can be carried forward 10 years Old law (2004 and previous tax return) –Back 2 years –Forward 5 years

25 FTC Carryovers Current year FTC used before carryovers Interaction with scaledown –If credit allocated to excluded income, no c/o –No further scaledown required when c/o FTC carrybacks claimed on 1040X Utilizing excess FTC Benefit of tax planning in non-US countries

26 FTC States may not recognize foreign tax credits, e.g., California does not recognize Alternative minimum tax (AMT) –Foreign tax credit can offset AMT –May have different FTC c/o for AMT purposes –Effective beginning in 2005, law allows full FTC for AMT purposes –Prior law limited FTC to 90% of AMT tax

27 Foreign tax credit (FTC) –How it works –Sourcing –Interaction with Sec 911 Key Points