The foreign tax credit is designed to help prevent double taxation of multinational companies’ foreign source income. But, to restrict or eliminate certain international tax planning techniques, Congress recently placed new limits on uses of the foreign tax credit. Therefore, companies with foreign income must exercise care to avoid unpleasant tax surprises. The international tax accountants at Doeren Mayhew explain.

Foreign Tax Credits: Simple Concept, Complex Process

As a general rule, U.S. companies are subject to U.S. income tax on all of their worldwide income. Foreign tax credits are designed to eliminate the unfairness that would result if a company were subject to tax in the United States as well as in a foreign jurisdiction on the same income.

Though complex in practice, the concept behind the foreign tax credit is simple: A U.S. company is entitled to claim a foreign tax credit against its U.S. income tax liability for any foreign income taxes it has paid or accrued. Suppose, for example, that a U.S. manufacturer builds a facility in a foreign country and earns $10 million in taxable income on sales there. If the foreign government imposes a 20 percent income tax, the manufacturer can claim a $2 million foreign tax credit against its U.S. tax liability for the year.

Foreign Subsidiaries Complicate Matters

Things get a bit more complicated when a U.S. company does business overseas through foreign subsidiaries. The Internal Revenue Code provides that, if a U.S. corporation owns at least 10 percent of a foreign corporation’s stock, it’s deemed to have paid foreign taxes based on the percentage it receives (in the form of dividends) of the foreign subsidiary’s total profits.

Take the example of a U.S. corporation that owns 50 percent of a foreign corporation. The foreign corporation earns profits of $10 million during the year and pays its U.S. parent a $2 million dividend. The parent is deemed to have paid 20 percent ($2 million/$10 million) of the subsidiary’s income tax bill and, therefore, can claim a foreign tax credit in that amount.

According to the IRS and the courts that have considered the issue, the 10 percent threshold is based on direct ownership. In one case, for example, five wholly owned domestic subsidiaries of a U.S. corporation together owned more than 10 percent of a foreign corporation’s stock, but none of the subsidiaries owned more than 10 percent by itself. Even though the subsidiaries filed consolidated tax returns, the IRS refused to aggregate their holdings in the foreign corporation. The agency denied the group the benefits of the foreign tax credit and the courts upheld the IRS position.

International Tax Planning Restrictions

Significant new restrictions on foreign tax credit planning have emerged via the Education Jobs and Medicaid Assistance Act of 2010. To offset the costs of funding new programs, the act prohibits certain planning techniques that enable U.S. companies to generate foreign tax credits for foreign taxes paid on income that isn’t subject to tax in the United States.

Among the situations likely to be affected are “covered asset acquisitions.” Under certain circumstances, a U.S. corporation that acquires a foreign target’s stock can treat the transaction as an asset purchase for U.S. tax purposes. The acquirer enjoys a stepped-up tax basis in the assets for U.S. tax purposes, but not for foreign tax purposes. This results in higher depreciation and amortization deductions — and, therefore, lower income — for U.S. tax purposes. In other words, the U.S. corporation generates tax credits based on foreign income that isn’t subject to tax in the United States.

The new law prohibits companies from claiming foreign tax credits attributable to differences in tax bases in such transactions. It also restricts foreign tax credit “splitting” and the so-called “hopscotch” rule, which allows accelerated foreign tax credits based on certain deemed dividends in connection with investments by controlled foreign corporations in U.S. property.

Minimizing Double Taxation

To minimize or eliminate double taxation on foreign income, companies that do business abroad need to review their eligibility for foreign tax credits. In some cases, there may be opportunities to restructure foreign operations to make the most of these credits.

For assistance exploring foreign tax credits for your business, contact the international tax accountants at Doeren Mayhew, with offices in Michigan, Houston and Ft. Lauderdale.