INTRODUCTION
While the word "basket" may trigger a mental image of a bicycle with a daisy basket that is a gift in early childhood, the term has a totally different connotation in the tax world. It denotes "foreign tax credit baskets" to an international tax geek in the U.S.
The foreign tax credit provisions are among the most complicated areas of the U.S. Internal Revenue Code ("Code"), and become further complicated when a "U.S. Shareholder" of a Controlled Foreign Corporation ("C.F.C.") includes income in one year but receives distributions in another.
This article explains the labyrinth of the foreign tax credit provisions that are encountered to ensure that (i) foreign source income and (ii) related foreign taxes are reported in the same foreign tax credit basket. If not computed properly, doubled taxation of income is sure to arise.
BACKGROUND
Here is a typical fact pattern involving a U.S. citizen who is a shareholder of a foreign owner-managed business.
- Mr. A is a U.S. citizen who is the sole shareholder of F Co, a corporation organized in country F.
- F Co serves as a holding company that has invested in several operating and investment companies outside the U.S.
- The ownership percentage of F Co in the foreign entities ranges between 1% and 50%.
- Dividends from the lower-tier foreign entities comprise F Co's main source of income.
- An income tax treaty is in effect between Country F and the U.S.
- The foreign entities timely distribute dividends to F Co.
- The divided income is treated as Subpart F income for Mr. A.
- Country F imposes a withholding tax rate of greater than 20% on distributions by F Co to Mr. A.
- F Co has not invested in any property in the U.S.
GENERAL OVERVIEW
General Rules
F Co is a C.F.C. for U.S. tax purposes. A C.F.C. is a foreign corporation of which more than 50% of its authorized and outstanding shares, measured by total voting power or value, is owned by one or more "U.S. Shareholders." A U.S. Shareholder is a U.S. person that owns shares representing 10% or more of the value or the voting rights of all shares of the foreign corporation.
Broadly speaking, a U.S. Shareholder of a C.F.C. is required to include in U.S. taxable income its pro-rata share of the income of the C.F.C. The income inclusion is required even though no actual distribution is made by the C.F.C. The income inclusion typically takes either of two forms, Subpart F income or Global Intangible Low-Taxed Income ("G.I.L.T.I.").1 Subpart F income typically includes passive income, for example, dividends, royalty, interest, royalty, etc. It also includes Foreign Base Company Income arising from related party transactions.2 Whereas G.I.L.T.I. refers to the excess of the income of the C.F.C. over certain deductions, including
- a deduction for Subpart F income,3
- a deduction for certain income specifically excluded from Subpart F Income,4
- a deduction for dividends from certain related parties,5
- a deduction for expenses (including taxes) properly allocable to tested gross income under G.I.L.T.I.,6 and
- a deduction for a hypothetical yield generated by the C.F.C. on its Qualified Business Asset Investment ("Q.B.A.I.").7
Application to Mr. A
Applying the Subpart F and G.I.L.T.I. rules to F Co, we see the following:
- F Co is a holding company and its income arising from dividends received from foreign entities would result in immediate U.S. taxation for Mr. A under the Subpart F provisions of U.S. tax law, except to the extent an exception applies.
- To the extent Mr. A is taxed immediately in the U.S. on income of F Co, subsequent distributions received from F Co will be viewed to be distributions of previously taxed income ("P.T.I.") for U.S. tax purposes. A distribution of P.T.I. is not subject to U.S. tax a second time.8
- Nonetheless, the distribution will be taxed in Country F at the time a distribution is made by F Co to Mr. A.
- In the year of distribution, Mr. A would also have a Subpart F inclusion for that year.
ORDERING RULE TO DETERMINE THE SOURCE OF ACTUAL DISTRIBUTIONS
General Rules
When a distribution is made by a C.F.C. to a U.S. Shareholder, it is important to determine the source of the distribution to determine the extent to which the distribution represents P.T.I. and non-P.T.I. As mentioned above, a distribution made by a C.F.C. to a U.S. Shareholder is not subject to U.S. tax on receipt if, and to the extent, it represents P.T.I.9 P.T.I. broadly describes the income of a C.F.C. that has already been subject to U.S. tax in the hands of a U.S. Shareholder under any of the anti-tax deferral regimes that exist under U.S. tax law, namely Subpart F, G.I.L.T.I., Transition Tax, and investments of earnings in U.S. property.
When an actual distribution is made by a C.F.C., it is important to determine its source for the following reasons:
- To determine the extent to which the distribution represents P.T.I. and the particular category of P.T.I. from which the distribution is deemed made
- To determine the U.S. tax treatment of the distribution based on the P.T.I. category it represents
- To properly adjust the P.T.I. categories to ensure that each category reflects the appropriate residual amount of P.T.I.
P.T.I. is classified into several categories based on the anti-tax deferral regimes. The following set of ordering rules is followed to determine the category of P.T.I. that serves as the source of the distribution:10
- First, the distribution is deemed to come from E&P that has been taxed to the U.S. Shareholder as investments of earnings in U.S. property ("U.S. Property P.T.I. E&P").11
- Second, to the extent the distribution exceeds the U.S. Property P.T.I. E&P, the distribution is deemed to come from the E&P that has been taxed to the U.S. Shareholder as Subpart F Income and G.I.L.T.I.12 ("Subpart F P.T.I. E&P") on a pro-rata basis.13
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- The amount subject to the Transition Tax is treated as an increase in Subpart F income ("Transition Tax P.T.I. E&P"). The amount is treated as included in the shareholder's gross income under Code §951(a) for purposes of Code §959.
- The Transition Tax P.T.I. E&P is given priority when determining the group of P.T.I. from which a distribution is made.14 This implies that the distribution is first deemed to be made out of the Transition Tax P.T.I. E&P until it is fully exhausted under the Subpart F P.T.I. E&P. Thereafter, it is allocated to the residual distribution among Subpart F and G.I.L.T.I.
- To the extent the distribution exceeds the foregoing two categories, the distribution is deemed to come out the E&P that has not been previously subject to U.S. tax at the level of the U.S. Shareholder ("Non-P.T.I. E&P").15
Within each of the three types of E&P categories, a distribution is first allocated to the current year E&P and then to E&P from prior years going backward in sequential order, regardless of actual source of the distribution for accounting or corporate governance purposes.16 In other words, a distribution is first allocated to the current year U.S. Property P.T.I. E&P, then to U.S. Property P.T.I. E&P of the immediately preceding year, followed by the second immediately preceding year, and so on so forth. The allocation continues in the backward order in the same P.T.I. category until either (i) the distribution amount is fully allocated or (ii) the P.T.I. in the P.T.I. E&P category is fully exhausted. Once the earning in the U.S. Property P.T.I. category is fully exhausted, the exercise of allocating the distribution amount continues under the Subpart F P.T.I. E&P category, starting with the current year, and going back to preceding years in a sequential order (giving the Transition Tax P.T.I. E&P priority). The exercise continues under the Non-P.T.I. E&P once the Subpart F P.T.I. E&P is depleted until the distribution amount is fully allocated.
Distributions to Mr. A out of the first two categories are excluded from the U.S. Shareholder's income. Distributions from Non-P.T.I. E&P are treated as taxable dividends. Taxable dividends are subject to U.S. tax in the hands of Mr. A rates of up to 20% if the dividends are treated as qualified dividends.17 Dividends that are not qualified dividends are generally taxed at ordinary rates of tax that are capped at 37% under current law, except that excess distributions received from a P.F.I.C. are taxed under the P.F.I.C.18 rules. Additionally, dividends are subject to the Net Investment Income Tax imposed at the rate of 3.8%.
Application to Mr. A
F Co has never invested in property in the U.S. and therefore, no portion of its E&P represents U.S. Property P.T.I. E&P. Therefore, any distribution made by F Co to Mr. A in 2025 would be deemed first to be made out of the 2025 Subpart F P.T.I. E&P. Any distribution in excess of the 2025 Subpart F P.T.I. E&P would be deemed to be made from the immediately preceding year's Subpart F P.T.I. E&P and so on and so forth. Mr. A would not be subject to U.S. tax on the distributions as long as the distributions represent the Subpart F P.T.I. E&P.
While the distribution would not be subject to U.S. income tax, Mr. A. would be subject to local withholding tax. At the same, Mr. A would be subject to U.S. income tax on Subpart F inclusion for the year of distribution.
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Footnotes
1. Other types of tax that may be imposed on a U.S. Shareholder of a C.F.C. include the Transition Tax for pre-2018 accumulated earnings and the tax on investments of earnings in U.S. property.
2. Foreign Base Company Sales Income (Code §954(d) and Foreign Base Company Services Income (e).
3. Code §951A(c)(2)(A)(i)(II).
4. Code §951A(c)(2)(A)(i)(III).
5. Code §951A(c)(2)(A)(i)(IV).
6. Code §951A(c)(2)(A)(ii).
7. Code §951A(b)(1)(B).
8. Code §959(b).
9. Code §959(a).
10. Ibid.
11. Code §959(c)(1).
12. Code §951A(f)(1)(A).
13. Code §965(b)(4)(A).
14. Section 3.2 of Notice 2019-1.
15. Code §959(c)(3).
16. Treas. Reg. §1.959-3(b).
17. Dividends distributed by a foreign corporation are treated as qualified dividends if (i) the foreign corporation is eligible for benefits under a comprehensive income tax treaty between the U.S. and the foreign corporation's country of residence, (ii) the determines the treaty is satisfactory, and (iii) the treaty includes an exchange of information program. See Code §1(h)(11)(c)(II). In no event is a dividend treated as a qualified dividend if the foreign corporation distributing the dividend a P.F.I.C. a surrogate foreign corporation under the anti-inversion rules. See Code §1(h)(11)(C)(iii)(I) and (II).
18 See Code §1291 et seq.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
