The world continues to get smaller, and more U.S. citizens are relocating internationally for both jobs and personal reasons. As a result, more U.S. citizens have to deal not only with U.S. taxation, but also with taxation in the jurisdiction where they reside. One of the main challenges for a U.S. tax adviser in these situations is determining how to minimize the client's overall effective global tax burden. A big part of the tax-minimization process is ensuring that the client maximizes his or her ability to use foreign tax credits.
The purpose of this discussion is to illustrate how challenging it can be to use foreign tax credits on qualified dividends. Consider the following:
Example: An unmarried U.S. citizen is taxed as a resident of the United Kingdom. In the United Kingdom, he has an active trade or business. The business is set up as a private limited company for U.K. tax purposes. No "check-the-box" election has been made. Therefore, the business will be treated as a C corporation for U.S. tax purposes. The U.K. company is a qualified foreign corporation under Sec. 1(h)(11)(C). The taxpayer owns 100% of the company. The company reports its income on a Dec. 31 year end, and the income it generates is not Subpart F income. On an annual basis, the company pays the taxpayer a U.K. salary of $50,000 and dividends of $100,000. The taxpayer's only U.S.-source income is $50,000 of interest income. The taxpayer needs to determine his overall tax liability for 2016, based on current law and tax rates for the year ended Dec. 31, 2016.
The taxpayer first calculates his U.K. tax liability on the above income. Using the remittance basis of taxation in the United Kingdom, the taxpayer pays $12,000 of U.K. tax on the $50,000 salary and $30,469 of U.K. tax on the $100,000 dividend payment.
Since the U.K. company is a qualified foreign corporation under Sec. 1(h)(11)(C), the dividend income it pays the taxpayer is qualified dividend income under Sec. 1(h)(11)(A) and, thus, is eligible for the favorable capital gains rates of Sec. 1(h).
In general, dividend income would be deemed to be passive category income under Secs. 904(d)(2)(A)(i) and 954(c)(1)(A) for foreign tax credit "basket" purposes. However, as the U.K. company is a controlled foreign corporation and all its earnings would be general category income, the dividend income is deemed to be general category income for foreign tax credit basket purposes, under Sec. 904(d)(3)(D).
The next step is to calculate the amount of foreign tax credit that the taxpayer can offset against his U.S. tax liability. Sec. 904 provides that the total amount of the foreign tax credit that the taxpayer can take cannot exceed the same proportion of the U.S. tax against which the credit is taken that the taxpayer's foreign-source taxable income bears to worldwide taxable income. Stated differently: The amount of creditable foreign income taxes that is available for the tax year = U.S. income tax (before credit) × foreign-source income ÷ worldwide taxable income.
In addition, if the taxpayer has foreign-source qualified dividends, he may be required to make certain adjustments to those amounts before he can take them into consideration as foreign-source income in the above equation under Regs. Sec. 1.904(b)-1.
When to make a qualified dividend adjustment (see instructions to Form 1116)
If the taxpayer has completed the "Qualified Dividends and Capital Gain Tax Worksheet" included in the instructions for Form 1040, U.S. Individual Income Tax Return, and has determined he does not have to file Schedule D, Capital Gains and Losses, he may have to adjust the amount of his foreign-source qualified dividends and capital gain distributions, if both of the following apply:
- Line 7 of the worksheet is greater than zero; and
- Line 25 of the worksheet is less than line 26 of the worksheet.
Note that the taxpayer does not have to make a qualified dividend adjustment if he meets both of the following criteria as a single taxpayer:
- Line 7 of the worksheet does not exceed $190,150; and
- The sum of foreign-source qualified dividends and capital gain distributions is less than $20,000.
Therefore, applying the above rules to the example, the taxpayer must calculate a qualified dividend adjustment when determining his foreign tax credit.
Calculating the qualified dividend adjustment
To adjust foreign-source qualified dividends or capital gain distributions, multiply the taxpayer's foreign-source qualified dividends or capital gain distributions in each separate category by 0.3788 if the foreign-source qualified dividends or capital gain distributions are taxed at a rate of 15%, and by 0.5051 if they are taxed at the 20% rate. Include the results on line 1a of Form 1116, Foreign Tax Credit. Adjust the foreign-source qualified dividends or capital gain distributions taxed at a 0% rate by excluding them from line 1a of Form 1116.
Based on the assumptions of income earned in the example, when the tax adviser prepares a 2016 Form 1040 treating the $100,000 dividend income as qualified dividend income, the regular tax liability on line 44 is $33,190 before any foreign tax credits. For purposes of calculating a foreign tax credit, a qualified dividend adjustment of $62,120 must be made on line 1a of Form 1116. After this adjustment, the taxpayer's foreign tax credit would be $20,975, with a resultant U.S. tax liability after credits of $12,215.
Thus, his overall tax burden is $54,684 ($12,000 (U.K. wage tax) + $30,469 (U.K. dividend tax) + $12,215 (U.S. tax after foreign tax credit)) on $200,000 of adjusted gross income.
Can further steps be taken to reduce the taxpayer's overall tax burden for 2016? The answer is "possibly."
Sec. 1(h)(2) provides that net capital gain, which would normally be subject to the preferential lower capital gains tax rates, will be reduced by the amount the taxpayer elects to take into account as investment income under Sec. 163(d)(4)(B)(iii); i.e., this investment income would be taxed at the taxpayer's marginal rate as ordinary income.
By treating the qualified dividend income as investment income, it is no longer subject to the qualified dividend adjustment for foreign tax credit purposes. This means that a larger percentage of the foreign taxes will be creditable against the taxpayer's U.S. tax liability. However, on the flip side, his U.S. tax liability is going to be larger because none of the dividends qualify for the preferential capital gains tax rates of 0%, 15%, or 20%.
If the taxpayer elects to treat the $100,000 of qualified dividend income as investment income, his regular tax liability on line 44 of Form 1040 is $46,139, before applying the foreign tax credit. The revised foreign tax credit is $34,604, resulting in a net U.S. tax liability of $11,535.
Thus, the taxpayer's overall 2016 tax burden is $54,004 (i.e., $12,000 + $30,469 + $11,535), which results in a tax savings of $680.
In summary, when a taxpayer has foreign-source qualified dividend income with foreign tax paid on the income, the tax adviser may need to test the tax return computations under the above two scenarios, i.e., qualified dividend income scenario versus investment income scenario, to determine which results in the lower overall tax burden.
An additional point to consider is that under the qualified dividend adjustment scenario in the above example, there is a regular tax foreign tax credit carryforward of $21,494. In the investment income scenario, there is a regular tax foreign tax credit carryforward of $7,865.
In effect, a tax savings now of $680 has potentially cost the taxpayer $13,629 in lost foreign tax credits. The tax adviser will have to determine if the taxpayer will ever be able to use those credits or whether they eventually will expire unused.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
