Foreign Income & Taxpayers

Foreign Tax Credits: Reducing Eight Categories to Two

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:

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:

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:

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:

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:

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.

From Don Jones, CPA, MBA, San Jose, CA

U.S. Withholding Tax Imposed on Foreign Tax-Exempt Organizations

Imagine an unsuspecting foreign charity that inherits some U.S. stock from a well-meaning decedent. When a foreign charitable organization earns U.S. source portfolio income it often has a choice to make: It can do the apparently obvious thing and claim tax-exempt status (and thus an exemption from U.S. withholding tax). However, that would require an IRS certification or legal counsel opinion letter confirming its status as a Sec. 501(c) equivalent. Both can be costly and may have unintended consequences. Alternatively, the organization may find it easier to refrain from asserting its tax-exempt status and opt for treatment as a (nonexempt) foreign organization.

Sec. 871(a) imposes a 30% flat tax on U.S. sourced fixed or determinable annual or periodical (FDAP) income of a nonresident alien individual. Under Sec. 881(a) the same 30% tax rate applies to the U.S. source FDAP income of a foreign corporation. The tax is withheld at source in connection with Secs. 1441 and 1442 and the regulations thereunder. Naturally, no such tax is imposed on the FDAP income derived by a foreign organization that enjoys tax-exempt status in the United States.

Claiming Tax-Exempt Status

The exemption from withholding on FDAP income paid to a foreign tax-exempt organization requires that the foreign organization qualify under Sec. 501(c) and that the income not constitute unrelated business taxable income.  Specifically, Regs. Sec. 1.1441-9(b)(2) requires that the foreign tax-exempt organization provide the U.S. withholding agent with a withholding certificate (Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding) along with a favorable IRS determination letter confirming its tax-exempt status, certifying what portion, if any, of the amounts received constitutes unrelated business income and specifying whether it is a private foundation described in Sec. 509. Alternatively, an opinion issued by U.S. counsel may be attached to the withholding certificate. An organization that provides an opinion by U.S. counsel may generally submit the same opinion to more than one withholding agent.

Note that special withholding rules and rates apply where the foreign tax-exempt organization earns unrelated business taxable income (see Sec. 1443). To the extent that the foreign tax-exempt organization is characterized as a private foreign foundation, it is subject to a 4% excise tax on its gross investment income. A foreign private foundation is described as an organization that is operated exclusively for charitable, religious, educational, or certain other purposes, if no part of its net earnings inures to the benefit of a private shareholder or individual (Sec. 509, Regs. Sec. 1.501(c)(3)-1(c)). It is determined to be a private as opposed to a public organization due to its sources of support, its activities, and its relationship to other excepted organizations. Gross investment income means the gross amount of income from interest, dividends, rents, payments with respect to securities loans and royalties, and similar sources, but not including any such income to the extent included in the foreign organization’s unrelated business income (Sec. 509(e)).

Once a foreign organization obtains tax-exempt status under Sec. 501, it may be required under Sec. 6033(a) to file an annual U.S. tax return (Form 990, Return of Organization Exempt from Income Tax). An exception may apply where the organization has gross receipts from U.S. sources of not more than $25,000 and has no significant activities in the United States (Rev. Proc. 94-17). The main reason a foreign charity may decide not to pursue a certification as a tax-exempt organization under U.S. tax principles is simply the cost associated with such a procedure. The documentation and disclosure requirements to be submitted to the IRS are substantial. Moreover, the costs of an opinion letter prepared by U.S. counsel may often exceed the tax liability it is supposed to avoid.

Claiming Treaty Benefits

If the foreign charity abstains from asserting tax-exempt status in the United States, it should issue a withholding certificate (Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) that establishes its foreign status and its beneficial ownership of the U.S. FDAP income. Where the organization is entitled to a reduced withholding tax rate with respect to, say, dividends or interest, it must be a qualified resident of a treaty country. Most income tax treaties recognize a charitable organization as a resident of the country where it is organized. However, the charity should also meet the limitation on benefits (LOB) clause under the respective treaty, which may contain additional requirements for the organization to be eligible for treaty benefits. For instance, the U.S.-Germany income tax treaty was only recently amended to eliminate such requirements. Before the new protocol became effective in December 2007, a German charitable organization could claim treaty benefits only if more than half of its beneficiaries were themselves entitled to treaty benefits.

In practice, foreign charities often send a Form W-8EXP to the U.S. withholding agent (or a qualified intermediary (QI)) that does not contain the necessary IRS determination or U.S. counsel opinion letter. Clearly, without such certification, the charity cannot be exempt from withholding. But could the withholding agent or QI reduce the withholding tax under a presumably applicable treaty? The answer is no. Although the withholding agent or QI can identify the organization’s country of residence based on the Form W-8EXP, this form does not contain the required LOB language to determine that the organization is entitled to reduced withholding tax rates under a treaty.

Filing U.S. Tax Returns

If the foreign charitable organization was subject to overwithholding due to incomplete documentation, it may wish to file a U.S. tax return to reclaim the excess taxes. It must then decide which form to file to receive the desired refund.

If the organization did not apply for tax-exempt status under U.S. tax principles (Sec. 501), it should not file a Form 990. The only feasible option appears to be Form 1120-F, U.S. Income Tax Return of a Foreign Corporation.

Under Sec. 7701(a)(3), the term “corporation” includes associations, joint-stock companies, and insurance companies. If the corporation is not organized under domestic law, it is considered to be foreign (Secs. 7701(a)(4), (5)). Whether an unincorporated tax-exempt organization can be treated as a corporation for U.S. tax purposes has been addressed by the IRS. In GCM 34502, the Service acknowledged that there are no separate regulations determining the U.S. tax classification of not-for-profit organizations, concluded that the business entity classification rules should accordingly apply, and suggested that the profit objective be replaced by “an objective to carry on, jointly, activities in furtherance of the purposes for which the instrumentality was formed.” In GCM 39461, the Service confirmed this position and referred to a much broader legal definition of an association as a “collection of persons who have joined together for a certain object.”

Based on the above, it seems appropriate for a foreign charity that does not qualify under Sec. 501 to take the filing position that it is a foreign corporation. This, of course, applies not only where the foreign charity claims a refund of U.S. withholding taxes, but also where the organization must file on an annual basis, for instance because it holds a partnership interest and is thus deemed to be engaged in a U.S. trade or business.

From Martin Karges, LL.M., and Anke Krueger, LL.M., New York, NY

Back
© 2008 AICPA