Foreign Tax Credits: Reducing Eight Categories to Two

Editor: Lorin D. Luchs, CPA, J.D., LL.M.

The foreign tax credit provided under Sec. 901 is limited by Sec. 904 to the portion of a taxpayer’s total tax equal to the ratio of the taxpayer’s taxable income from sources outside the United States to the taxpayer’s entire taxable income for the same tax year. Under Sec. 904(d), this foreign tax credit limitation is computed separately for different categories of income. The American Jobs Creation Act of 2004, P.L. 108-357, reduced the foreign tax credit limitation categories from eight to two: passive category income and general category income.

On December 21, 2007, the IRS issued final and temporary regulations under Sec. 904(d) (TD 9368). The regulations are effective December 21, 2007, and apply to tax years of U.S. taxpayers beginning after 2006 and ending on or after December 21, 2007.

Reducing the number of separate foreign tax credit limitation categories presents a number of interesting transitional issues that the new regulations attempt to clarify. The regulations provide transition rules for the treatment of:

• Earnings and profits (E&P) and foreign income taxes of controlled foreign corporations (CFCs) and noncontrolled Sec. 902 corporations (foreign corporations) accumulated in pre-2007 tax years;
• Recapture and allocation of overall foreign losses and separate limitation losses; and
• Carryover and carryback of excess foreign tax credits.

Transition of Foreign Corporation’s Post-1986 E&P and Foreign Taxes

The temporary regulations implement the reduction of separate categories by recharacterizing the pools of post-1986 E&P and foreign taxes in the pre-2007 separate categories as pools of post-1986 E&P and foreign taxes in the passive and general categories on the first day of the CFC or a noncontrolled foreign corporation’s first post-2006 tax year. These rules also apply to the post-1986 E&P and foreign taxes of lower-tier foreign corporations as well (see Regs. Sec. 1.904-7T(g)(5)).

Regs. Sec. 1.904-7T(g) provides that in order to substantiate the recharacterization, the E&P and foreign tax pools must be reconstructed for each pre-2007 tax year beginning with the first year in which the earnings were accumulated with respect to each pre-2007 separate category. Once reconstructed, the pools of earnings and taxes in a pre-2007 separate category are assigned to the post-2006 separate categories on the first day of the foreign corporation’s first post-2006 tax year.

Similar rules apply to recharacterize pre-2007 previously taxed E&P under Sec. 959(c)(1)(A), accumulated deficits, and pre-1987 accumulated profits. In other words, when reconstructing each pre-2007 tax year, the computation of E&P, previously taxed income, deficits, and pre-1987 accumulated profits is performed as if the post-2006 separate category rules applied.

Safe Harbors

Recognizing that reconstructing pre-2007 E&P and foreign tax pools year by year can be a burdensome task, the regulations allow a taxpayer to elect one of two safe harbors in lieu of reconstructing the foreign corporation’s historical E&P and foreign tax pools (Temp. Regs. Sec. 1.904-7T(g)(3)(ii)).

The first safe harbor, under Temp. Regs. Sec. 1.904-7T(g)(3)(ii)(B)(1), provides that undistributed post-1986 E&P and foreign taxes in a foreign corporation’s pre-2007 separate category for:

• Passive income;
• Certain dividends from a domestic international sales corporation (DISC) or former DISC;
• Taxable income attributable to certain foreign trade income (FTI); and
• Certain distributions from a foreign sales corporation (FSC) or former FSC

shall be allocated to the post-2006 separate category for passive category income. Post-1986 undistributed E&P and foreign taxes in a foreign corporation’s pre-2007 separate category for:

• Financial services income;
• Shipping income; and
• General limitation income

shall be allocated to the post-2006 separate category for general category income.

Special rules apply to high withholding tax interest income. In general, if the high withholding tax interest post-1986 E&P pool would qualify as income subject to high foreign taxes under Sec. 954(b)(4), such earnings and foreign taxes shall be allocated to the post-2006 separate category for general category income. Otherwise, the earnings and foreign taxes shall be allocated to the post-2006 separate category for passive category income.

The second safe harbor, under Temp. Regs. Sec. 1.904-7T(g)(3)(ii)(C), allows taxpayers to allocate the foreign corporation’s post-1986 E&P and foreign taxes to the post-2006 separate categories based on the interest apportionment safe-harbor rules of Temp. Regs. Sec. 1.904-7T(f)(4)(ii).

Transition for Separate Limitation Losses and Overall Foreign Losses

The rules under Temp. Regs. Sec. 1.904(f)-12T(h) provide that where a taxpayer has an overall foreign loss (OFL) or separate limitation loss (SLL), at the end of the taxpayer’s last pre-2007 tax year, in the pre-2007 separate category for:

• Passive income;
• Certain dividends from a DISC or former DISC;
• Taxable income attributable to certain FTI; and
• Certain distributions from an FSC or former FSC

such OFL or SLL is allocated on the first day of the taxpayer’s next tax year to the taxpayer’s post-2006 separate category for passive category income.

Similarly, if the taxpayer has an OFL or SLL in the pre-2007 separate category for:

• Financial services income,
• Shipping income, and
• General limitation income,

such OFL or SLL is allocated on the first day of the taxpayer’s next tax year to the taxpayer’s post-2006 separate category for general category income. Special rules under Temp. Regs. Sec. 1.904(f)-12T(h)(3) apply to high withholding tax interest.

The temporary regulations provide an alternative for determining the treatment of OFLs and SLLs in pre-2007 separate categories. This alternative follows the principles of the transition rules of Temp. Regs. Secs. 1.904-12T(g)(1) and (2) regarding the treatment of OFLs and SLLs in the separate category for dividends from a noncontrolled Sec. 902 corporation (Temp. Regs. Sec. 1.904-12T(h)(5)).

Transition of Carryovers and Carrybacks of Excess Foreign Taxes

Temp. Regs. Sec. 1.904-2T(i)(1)(i) provides that if a taxpayer carries over to a post-2006 tax year any excess taxes that were paid, accrued, or deemed paid with respect to income in any pre-2007 separate category, the excess taxes are assigned to the appropriate post-2006 separate category as if the taxes had been paid or accrued in a post-2006 tax year.

Temp. Regs. Sec. 1.904-2T(i)(1)(ii) provides a safe harbor to ease the burden of reconstructing excess taxes from pre-2007 tax years by providing that the taxpayer may assign excess taxes in any pre-2007 separate category (except the passive category) to the post-2006 separate category for general category income. Excess taxes in the pre-2007 passive category will be assigned to the post-2006 separate category for passive category income.

Temp. Regs. Sec. 1.904-2T(i)(2)(i) provides that if a taxpayer carries back excess taxes paid, accrued, or deemed paid with respect to income in the post-2006 separate category to a pre-2007 tax year, the excess taxes are assigned to the appropriate pre-2007 separate category as if the taxes had been paid or accrued in a pre-2007 tax year. In lieu of reconstructing post-2006 taxes to a pre-2007 tax year, the taxpayer may choose the alternative rule under Temp. Regs. Sec. 1.904-2T(i)(2)(ii), which assigns excess taxes for the separate category for general category income to the pre-2007 general category, and excess taxes in the separate category for passive category income to the pre-2007 passive category.

EditorNotes

Lorin D. Luchs, Partner, Washington National Tax Office BDO Seidman, LLP, Bethesda, MD.

Unless otherwise indicated, contributors are members of or associated with BDO Seidman, LLP.

If you would like additional information about these items, contact Mr. Luchs at (301) 634-0250 or lluchs@bdo.com.