In Part 1 of this Series 204: US Based Companies with Foreign (i.e. Outbound) Operations, we covered the potential pitfalls out having operations abroad, namely, through the use of corporations. This part will cover those provisions that help alleviate any potential negative dual layers of taxation, provide special deductions, and allow for tax-free repatriation of income. We will cover the following major topics–
- Foreign Tax Credits
- Tax Free Repatriation of Income: Dividends Received Deduction & Previously Taxed Earnings and Profits
- Foreign Derived Intangible Income Deduction
Foreign Tax Credits
As we mentioned in Series 203: US International Tax Systems for Businesses, there is potential that when a US individual or business operates in a foreign country that they will be subject to tax, twice, on the same income earned. This occurs when a foreign country imposes a tax on income earned within the country, and the US then again imposes a tax on the same income. Seems punitive, right? Well luckily the US government agrees with you and provides relief from this double taxation through various provisions in the Internal Revenue Code (IRC) and applicable tax treaties. The most impactful provisions of these is that of the Foreign Tax Credit (FTC).
Essentially, the FTC allows a US individual or person to take a credit against their US tax liability for foreign income taxes paid on foreign income subject to tax in the US. While it sounds simple, this is a highly complex provision that has accounting and legal professionals alike dedicate their whole careers to understanding and calculating for their clients. The complexity of this provision arises from the limitations imposed on the use of the credit.
So, what foreign taxes is the FTC allowed for? Generally, the FTC is allowed for any income, war profits, and excess profits taxes paid or accrued in a given tax year to a foreign country. This also includes taxes paid in lieu of income, as well as taxes withheld on income earned in foreign countries.
As we mentioned earlier, the FTC is subject to several limitations. Simply put, the FTC is limited such that it is only credited against US tax on foreign source income. The FTC limitation calculation can be expressed by the following equation:
(Foreign Source Income / Worldwide Income) X US taxes
To determine what is foreign source income, we must look to IRC 861 and its regulations. IRC 861 and its regulations are long and nuanced, a full conversation of which is beyond the scope of this article. However, it generally includes income from all geographic sources outside the US. It does not matter whether the foreign income is from one country or many countries.
The denominator of this equation is self-explanatory—worldwide income consists of the taxpayer’s income from both foreign and domestic sources.
Finally, US taxes represents the taxpayer’s total gross US tax liability for the given tax year.
To further the complication of this limitation, the limitation is tracked amongst separate types of income. Specifically, there are four “buckets” and/or “baskets” of income that the FTC tracked against—general category income, passive category income, IRC 951A Global Intangible Low Tax Income (“GILTI”), and foreign branch income.
General category income follows its general definition, and generally includes income from an individual’s or corporation’s active trade or business. In addition, general category income includes, most importantly, amounts deemed included in the income of US shareholders from the ownership of “controlled foreign corporations” under the Subpart F regime. The Subpart F regime and corollary income inclusions due to ownership of “controlled foreign corporations” are discussed in Part 1 of this Series 204. As part of this Subpart F inclusion in the general category basket, domestic corporate taxpayers can claim a deemed foreign tax credit with respect to their deemed income inclusion under Subpart F.
Passive income also follows its normal definition, and generally includes rents, royalties, interest, dividends, and other investment income that the individual does materially participate in. Specifically, it includes income classified as Foreign Personal Holding Company Income for purposes of the Subpart F regime. You can revisit this definition in Part 1 of this Series 204. A special rule to note is a “look through” rule that applies when a “controlled foreign corporation” pays dividends, interest, rents and royalties, or deemed to pay such items via the Subpart F regime, to its US shareholders. The passive income received from the “controlled foreign corporations” is re-assigned to the general income basked to the extent the income is attributable to income that would otherwise fall in the general category bucket.
The basket for foreign branch income is a new FTC category added by the recent passage of the Tax Cuts and Jobs Act of 2017 (TCJA). The basket consists of business profits earned by a US person attributable to foreign branches operating in foreign countries A foreign branch, or more specifically, a “qualified business unit” for purpose of this basket includes a separate and clearly-identified unit of a taxpayer’s business which maintains separate books and records. Generally, income for this basket is attributable to a foreign branch or disregarded entity the taxpayer operates in a foreign country. Foreign income taxes paid on foreign branch income are accounted for as part of this basket.
The last basket to discuss includes income via the GILTI provision applicable to “controlled foreign corporations”. To learn more about what GILTI consists of, please visit our discussion in Part 1 of this Series 204. For purposes of the FTC limitation, a US shareholder of a “controlled foreign corporation” that has income arising from the GILTI provision can claim a deemed paid FTC with respect to the portion of the foreign taxes their subsidiary foreign corporation paid on the GILTI inclusion. However, it is important to note that this deemed paid FTC is only allowed for corporate shareholders, and not individuals. Individuals are not entitled to take any sort of FTC on income allocable to them via the GILTI provision.
You may be asking yourself, what if I have a foreign loss in one basket of income and foreign income in another basket of income? These losses can be used to offset foreign income in another category of income for FTC purposes. If the losses from one category are in excess of the aggregate amount of foreign income earned in all other basked, then the foreign loss can be used to offset domestic income for purposes of calculating the FTC limitation. This rule prevents taxpayer form claiming net income in one basket and a net loss in a second basket. The net loss in one basket should reduce the foreign source net income (not below zero) in the second basket, reducing the amount of FTC available in the second basket. If, however, the loss from one basket excess the income from all other baskets, you have an “overall foreign loss” that can be used to offset domestic source income for purposes of this calculation. If there is an “overall foreign loss”, and the taxpayer earned a foreign source profits in subsequent years, then a minimum of such foreign profits earned in the subsequent year must be reclassified as domestic source income. Similarly to this rule, if a foreign loss is allocated against foreign income of another basket, the former basket must recharacterize its foreign source income as the latter baskets income in subsequent years. The FTC limitation and basket system is extremely complex, but allows for large planning opportunities. If you are interested in having a team member analyze your position and look for opportunities please schedule a consultation.
The final note for FTCs is their carry forward ability. Foreign taxes paid or accrued that exceeds the amount of the overall limitation may be carried forward up to 10 years, and even carried back in the preceding year to the extent allowed by the FTC limitation calculated for the preceding or carryforward year.
Tax Free Repatriation of Income
Dividends Received Deduction & Previously Taxed Earnings and Profits
A tax-free repatriation of income is what every company with foreign operations aims for. Prior to the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, a domestic corporation was only entitled to tax-free repatriation when bringing foreign income back to the US that had already been subject to tax. If the foreign income was earned directly by the domestic corporation, then such income was generally subjected to tax and could be transferred back to the US with no additional tax consequences. However, if the foreign income was earned through a foreign corporate subsidiary, a number of different situations could arise. As we discussed in Part 1 of Series 204, a foreign corporate subsidiaries income is only subject to tax in certain situations. If the foreign corporate subsidiary’s income had been subject to tax in the US due to anti-income deferral measures passed under Subpart F, then the repatriation of income was generally tax-free. However, if a foreign corporate subsidiary’s income had escaped taxation in the US, the repatriation of income back to the US would generally be subjected to tax.
As you can see, the nuances as to the taxation of repatriating foreign income generally applies to foreign income earned by foreign corporate subsidiaries. In order to track what foreign income of a foreign corporate subsidiary had been subjected to tax, and what had not, the US tax system implemented a concept that is known as “Previously Tax Earnings & Profits”. Essentially, the US tax system would and still does track what income of a foreign corporate subsidiary has been subjected to tax and what income has not. The nuances of this concept are broken down below, however, if an item of income repatriated back to the US from a foreign corporate subsidiary was attributable to “Previously Taxed Earnings & Profits”, then it was not subject to tax when brought back to the US. But, if such income repatriated was not attributable to “Previously Taxed Earnings & Profits”, then the repatriation of such income would be subjected to tax.
This system of tracking “Previously Taxed Earnings & Profits” has been an integral key to the US’s international tax system for a number of years. However, the passage of the TCJA in 2017 added a new provision that revolutionized the US’s system regarding the repatriation of foreign income from foreign subsidiaries. This provision is otherwise known as the new IRC 245A “Dividends Received Deduction” (the DRD). The DRD was implemented to coincide with the new territorial international tax system the US looked to implement. In a nutshell, the new DRD allows US shareholders with certain ownership percentages of a foreign corporation to exclude from income the foreign-source portion of any dividend paid to them by said foreign corporate subsidiary.
These two provisions together generally control what foreign income is free of taxation when repatriated to the US.
Dividends Received Deduction
There are some mechanical rules we will cover to show you which US shareholders are entitled to the DRD.
The DRD permits a domestic corporation that qualifies as a US Shareholder of a specified 10% owned foreign corporation to deduct 100% of the foreign-source portion of any dividend received from such foreign corporation.
As you will note, there are three inherent limitations to taking advantage of this provision. First, only domestic corporations, and not individuals and trusts, are entitled to the DRD. Additionally, the dividend must be from a specified 10% owned foreign corporation. Finally, the deduction is limited to the foreign-source portion of the dividend received.
The limitation of being a domestic corporation is self-explanatory. However, what about a specified 10% owned foreign corporation? This means that the domestic corporation must own at least 10% of the foreign corporation’s stock, measured being either voting power or value. If so, the foreign corporation qualifies for this standard.
However, what qualifies as the “foreign-source portion” of a dividend? Generally, to qualify, the dividend must be paid out of the foreign earnings of the foreign corporation; dividends paid out of domestic earnings of foreign corporations are subject to a different set of tax rules. The foreign-source portion of a dividend is calculated by multiplying the dividend received by a fraction, the numerator of which is the foreign corporation’s undistributed foreign earnings and profits, and the denominator of which is the foreign corporation’s total undistributed earnings and profits.
What we have yet to mention is the required holding period of a foreign corporate subsidiaries stock to qualify for this treatment. The DRD cannot be claimed unless the domestic corporation has held the foreign corporation’s stock for more than 365-days over the 731-day period that beings on the date that is 365 days before the date on which the dividend is paid. In addition to this required holding period, the foreign corporation must have been a specified 10% owned corporations, and the domestic corporation must be a US shareholder (i.e. owning more than 10% of the foreign corporation’s stock).
Previously Taxed Earnings & Profits
To ensure that income earned by a foreign corporate subsidiary that has already been subjected to tax in the US is not once again subjected to tax when repatriated back to the US, a nuanced, mechanical set of rules was created by the government to essentially track income previously subjected to tax. When the safeguard rules under Subpart F (as discussed in Part 1 of this Series 204), and there is no actual distribution of income, the IRC treats the US shareholder as if they contributed the deemed dividend back to the corporation, thereby increasing their “tax basis” in the foreign corporation’s stock. Once there is an actual distribution of income from the foreign corporate subsidiary, a mechanism is implemented in the IRC to the reverse the increase to “tax basis”.
This mechanism, found under IRC 959, provides that income subject to taxation via the safeguard rules of Subpart F (and other certain anti-deferral measures) are insulated from taxation when later distributed. This mechanism tracks previously taxed income by income type and provides ordering rules when determining whether cash repatriated is subjected to tax.
Tax Free Repatriation Conclusion
The provisions governing tax free repatriations of income to the US are nuanced and full of pitfalls. If you would like assistance in determining whether earnings and profits sitting overseas is entitled to tax free repatriation to the US, please contact our office to assist you make a determination.
Foreign Derived Intangible Income (FDII)
Foreign Derived Intangible Income, better known by its acronym FDII, was recently passed as part of the TCJA of 2017. This provision was intended to incentivize he ownership of intellectual property in the US or the centralizing of certain manufacturing or property producing processes here in the US. Its incentives match some of the then US President’s, Donald J. Trump, goals to bring jobs back to the US and lessen the US’s trade deficit. In a nutshell, FDII provides domestic corporations a 37.5% deduction on income derived from the sale or disposition of property to a foreign person for a foreign use. This incentive is extremely mechanical and requires an analysis of its varying parts.
This inventive generally allows U.S. corporate taxpayers a deduction equal to the sum of 37.5% of their FDII (21.875% for tax years beginning after 2025), resulting in a tax rate on such income of 13.125% (16.406% for tax years beginning after 2025). The calculation of FDII can be expressed as the following formula:
(Deduction Eligible Income (DEI) – 10% of Qualified Business Asset Investment (QBAI))
(“Foreign-Derived Deduction Eligible Income” ÷ DEI)
We will in turn go through each one of these terms.
Deduction Eligible Income (DEI)
DEI generally equals gross income of the corporation without regard to Subpart F income, inclusions via GILTI, dividends received from 10% owned CFCs, domestic oil and gas income, and foreign branch income, all as reduced by deductions, including taxes, properly allocable to this income.
Qualified Business Asset Investment (QBAI).
QBAI is determined as the average of the aggregate basis of the corporation’s adjusted basis in specified tangible property that is used in the corporation’s trade or business and for which a depreciation or similar deduction is allowable. This adjusted basis is computed as the close of each quarter of the tax year. Thus, the takeaway here is that only taxpayers whose income exceeds 10% of their depreciable tangible property basis will have DEI and therefore will be eligible for the deduction.
Foreign-Derived Deduction Eligible Income
Foreign derived deduction eligible income constitutes income derived from property sold by the taxpayer to a non-U.S. person and that is for foreign use or consumption or that is derived in connection with services provided by the taxpayer to a person, or with respect to property, that is not located in the United States. For purposes of determining foreign-derived deduction eligible income, the terms, “sold,” “sells,” and “sale” includes any lease license, exchange, or other disposition.
While you can see the calculation of the FDII incentive is very mechanical in nature, the policy behind this incentive is easily explainable—to encourage the ownership of intellectual property and other manufacturing and producing process here in the US, while simultaneously aiming to lower the US’s trade deficit. By providing a deduction on all income from products, services, intellectual property sold by a US-based company to a foreign person for foreign use, many companies are looking to restructure their operations to take advantage of this favorable incentive.