The IRS has released a new Form 1118, “Foreign Tax Credit — Corporations,” and new instructions along with it. The agency notes that, to incorporate the provisions of the Tax Cuts and Jobs Act (TCJA), extensive changes have been made to both.
The United States, its possessions and foreign countries may tax the foreign-source income of U.S. taxpayers. The amount of taxes imposed by U.S. possessions and foreign countries is allowed as a credit against U.S. taxes under Internal Revenue Code Section 901. If the credit is taken, a deduction for the taxes isn’t allowed.
The foreign tax credit is limited to the U.S. tax on foreign-source income. This ensures that the credit only mitigates double taxation of foreign-source income without offsetting U.S. tax on U.S.-source income.
The foreign tax credit limitation is calculated separately for certain categories, or “baskets,” of income. Under pre-TCJA law, there were two such baskets: passive income and general income (defined as income other than passive income). The amount of foreign taxes paid or accrued that exceeded the foreign tax credit limitation for a tax year could be carried forward up to 10 years or carried back one year.
On December 22, 2017, President Trump signed into law the TCJA. It made far-reaching changes to the treatment of foreign taxes and the foreign tax credit.
Impact of tax law reform
The TCJA makes the following changes to the calculation of foreign tax credits for post-2017 tax years:
Two new foreign tax credit limitation categories. Section 904(d) was amended to add two new baskets for determining the allowable foreign tax credit:
- GILTI. Shareholders of controlled foreign corporations (CFCs) must include in gross income their global intangible low-taxed income (GILTI) for the tax year in a similar manner to Subpart F income (certain income earned by CFCs, which certain U.S. shareholders generally must currently recognize). Any amount includible in gross income as GILTI other than passive basket income is included as a separate foreign tax credit basket. These changes go into effect for tax years of foreign corporations beginning after December 31, 2017, and tax years of U.S. shareholders in which or with which those tax years of foreign corporations end.
- Foreign branch income. For tax years that begin after December 31, 2017, foreign branch income must be allocated to a specific foreign tax credit basket. Foreign branch income is defined as the business profits of a U.S. person attributable to one or more qualified business units in one or more foreign countries.
Repeal of Sec. 902 indirect credits with respect to dividends from foreign corporations. No foreign tax credit or deduction is allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the deduction for a foreign-source portion of dividends applies. This change applies to tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Under the former Sec. 902 deemed-paid or indirect credit, a U.S. corporation that owned 10% or more of the voting stock of a foreign corporation was permitted to claim a credit. The credit was for a portion of the foreign taxes paid by that corporation for which the U.S. corporation was treated as having paid when the income on which the foreign tax was paid was distributed to the shareholder as a dividend.
Modification of indirect credits under Sec. 960 for inclusions under Sec. 951(a)(1) and Sec. 951A. Under Sec. 960, a foreign tax credit is allowed for any subpart F income that’s included in the income of the U.S. shareholder on a current-year basis. Under Sec. 951(a)(1), 10% U.S. shareholders of a CFC are required to include in income their pro rata share of the CFC’s Subpart F income, whether or not this income is distributed to them.
If a domestic corporation takes into income a Subpart F inclusion as to a CFC in which it’s a U.S. shareholder, the domestic corporation is deemed to have paid as much of the foreign corporation’s foreign income taxes as is properly attributable to that income. For purposes of the CFC provisions, if any amount is includible in the gross income of a domestic corporation as GILTI, that domestic corporation is deemed to have paid foreign income taxes equal to 80% of the product of the domestic corporation’s inclusion percentage multiplied by the aggregate tested foreign income taxes paid or accrued by CFCs.
Modification of Sec. 78 gross-up with respect to inclusions under Sec. 951(a)(1) and Sec. 951A. If a domestic corporation chooses to take a foreign tax credit for any tax year, an amount equal to the taxes deemed to be paid by that corporation under Sec. 960(a), Sec. 960(b) and Sec. 960(d) for that tax year — determined without regard to the phrase “80%” in Sec. 960(d)(1) — is treated for income tax purposes (other than Sec. 245 and Sec. 245A) as a dividend received by that domestic corporation from the foreign corporation. This goes into effect for tax years of foreign corporations beginning after December 31, 2017, and tax years of U.S. shareholders in which or with which the tax years of foreign corporations end, under Sec. 78.
Revised sourcing rule for certain income from the sale of inventory under Sec. 863(b). For tax years that begin after December 31, 2017, gains, profits and income from the sale or exchange of inventory property produced partly in and partly outside the U.S. must be allocated and apportioned based on the location of production with respect to the property.
For example, income derived from the sale of inventory property to a foreign jurisdiction is sourced wholly within the United States if the property was produced entirely in the United States — even if title passage occurred elsewhere. Likewise, income derived from inventory property sold in the United States but produced entirely in another country is sourced in that country even if title passage occurs in the United States. If the inventory property is produced partly in and partly outside the United States, the income derived from its sale is sourced partly in the United States.
New adjustments for purposes of Sec. 904 with respect to expenses allocable to certain stock or dividends for which a dividends-received deduction is allowed under Sec. 245A. Under the TCJA, if a domestic corporation that’s a U.S. shareholder of a 10% owned specified foreign corporation receives a dividend from that foreign corporation, a deduction is allowed for the foreign-source portion of the dividend.
For purposes of determining the foreign tax credit limitation, in the case of a domestic corporation that’s a U.S. shareholder of a specified 10% owned foreign corporation, the shareholder’s taxable income from sources outside the United States (and entire taxable income) is determined without regard to the foreign-source portion of any dividend received from that foreign corporation. This determination is also made without regard for any deductions properly allocable or apportioned to:
- Income other than amounts includible as Subpart F income under Sec. 951(a)(1) or as global intangible low-taxed income under Sec. 951A(a), with respect to stock of that specified 10% owned foreign corporation, or
- Such stock to the extent income with respect to the stock is other than amounts includible in Subpart F income or global intangible low-taxed income.
Thus, for deductions for tax years ending after December 31, 2017, dividends allowed as a Sec. 245A dividends-received deduction aren’t treated as foreign-source income for purposes of the foreign tax credit limitation.
Election to increase pre-2018 Sec. 904(g) overall domestic loss recapture. Under Sec. 904(g)(5), for any tax year of the taxpayer that begins after December 31, 2017, and before January 1, 2028, a taxpayer may, with respect to pre-2018 unused overall domestic losses, elect to substitute, for a 50% amount, a percentage greater than 50% but not greater than 100%.
Under pre-TCJA law, for purposes of the limitation on the foreign tax credit, if a taxpayer sustains an overall domestic loss for any tax year, then, for each succeeding year, an amount of U.S.-source taxable income equal to the lesser of either: a) the full amount of the loss to the extent not carried back to prior tax years, or b) 50% of the taxpayer’s U.S.-source taxable income for that succeeding tax year, is recharacterized as foreign-source income.
Limited foreign tax credits with respect to inclusions under Sec. 965. For the last tax year of a deferred income corporation beginning before January 1, 2018, in a specified foreign corporation’s last tax year before the transition to the participation exemption system, the corporation’s Subpart F income is increased by its accumulated deferred foreign income. In addition, its U.S. shareholders must include in income their pro rata share of that Subpart F income (in other words, the mandatory inclusion).
However, a U.S. shareholder of a deferred foreign income corporation is allowed a deduction for the tax year in which a mandatory inclusion is included in the gross income of the U.S. shareholder. Under Sec. 965(g)(1), no foreign tax credit is allowed under Sec. 901 for the applicable percentage of any taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which the deduction (described above) is allowed. Under Sec. 965(g)(3), no deduction is allowed for any tax for which a credit isn’t allowable under Code Sec. 901 under the above rule (determined by treating the taxpayer as having elected to take the foreign tax credit).
The instructions for Form 1118 note that several of the foreign tax credit provisions of the TCJA are applicable to tax years of foreign corporations beginning after December 31, 2017, and to tax years of U.S. shareholders in which or with which such tax years of the foreign corporations end (post-2017 foreign corporate tax year). Therefore, if the foreign corporation’s year begins before 2018 (pre-2018 foreign corporate tax year), some pre-enactment rules continue to apply in the domestic corporation’s tax year beginning in 2018.
For instance, if a domestic corporation with a calendar tax year owns a foreign corporation with a U.S. tax year beginning on December 1, 2017, and ending on November 30, 2018, for its 2018 tax year the domestic corporation is subject to certain pre-enactment provisions with respect to the foreign corporation.
But if the domestic corporation also owns a foreign corporation with a U.S. tax year beginning on January 1, 2018, and ending on December 31, 2018, for its 2018 tax year the domestic corporation is subject to certain postenactment provisions with respect to the foreign corporation. Accordingly, the Form 1118 continues to require reporting under pre-enactment provisions, as well as requiring new reporting for postenactment provisions.
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The changes to the foreign tax credit under the TCJA are complex. The Elliott Davis International Practice Group is here to help. Contact any of our professionals to see how we can assist your business.
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