U.S. Taxation of Foreign Transactions

Posted on June 8, 2024

TAXING SYSTEMS

There are two types of taxing systems, generally followed -

WORLDWIDE TAX SYSTEM

The U.S. Tax System is classified as a worldwide tax system because its citizens and residents are generally subject to tax on their worldwide income.

TERRITORIAL TAX SYSTEM

• Under this system, a nation only taxes its citizens and residents on income earned inside its borders
• Income earned outside the country's borders is not subject to tax
• Countries that are member of "Organization for Economic Co-operation and Development" (OECD)- employ a territorial style tax system

WAYS TO OFFSET POTENTIAL DOUBLE-TAXATION

Dividends-Received Deduction

• The Tax Cuts & Jobs Act (TCJA) of December 2017 allows U.S. Corporations earning dividend income outside of the U.S. to take a 100 percent dividends-received deduction against the foreign income.

Foreign Tax-Credit

• Foreign tax-credit is mainly allowed to mitigate the double-taxation concept.
• The United States allow U.S. taxpayers to take a foreign tax-credit for income taxes paid to a foreign government.
• If a U.S. taxpayer earns income in a foreign jurisdiction within higher rate of taxes than the U.S., no residual taxes will be paid to the U.S. government. They will be completely eliminated.
• The foreign tax-credit will be limited to the amount of the U.S. taxes attributable to the foreign source income.
• It also ensures that the U.S. Tax liability tied to the income earned in the U.S. is not offset by an unlimited tax credit.

Foreign Tax-Credit Limitation Calculation:

Pre-Credit U.S. Tax on total taxable income * (multiplied by) Foreign Source Income / Total taxable income **

** Total taxable income includes both foreign source income and all other taxable income, including domestic income.

• The Foreign Tax-credit has to be lesser of the above calculated amount or the actual foreign taxes paid.

Separate Limitation Calculations

• Foreign income is sourced into separate categories to prevent a company from using excess credits from high-tax foreign business profits to offset low-taxed passive investment income.
• The foreign tax-credit limitation is applied separately to each of the following categories on income:
• Passive category income (dividends, interest, rents, royalties)
• General category income (active business income)
• Foreign Branch income
• Global intangible low-taxed income

Calculating the Foreign Tax-Credit Limitation by Category

• The foreign tax-credit is allowed for a foreign tax that the U.S. deems to be an income-tax. This does not include sales-tax, value added taxes , property taxes or custom taxes.
• The credit allowed is the lesser of the limitation for the category of income or the foreign taxes related to the category of income.
• The total foreign tax-credit (FTC) is then the sum of the credits allowed for all categories.
• A corporation calculates and reports its foreign tax credit on Form 1118 Foreign Tax-Credit Corporation.
• Individuals, Estates and Trusts use Form 1116 Foreign Tax-Credit (Individuals, Estate & Trust)
• Taxpayers can elect to deduct foreign taxes rather than claim the credit which can be a good decision if the taxpayer does not expect to utilize the credit in the 10-year carryforward period.

Special Rules

• No Double Dipping allowed - that is, corporations cannot take the benefit of foreign tax-credit and the 100 percent 'Dividends-received-Deduction" simultaneously. It has to be one or the other.
• The deduction is subject not only to a 10 percent ownership of the foreign company's stock by the U.S corporation but also the holding period requirement, which requires that the U.S. Corporation holds the foreign corporation stock for more than 365 days during the 731 day period beginning 365 days before the ex-dividend date.
• Certain income is not eligible for the 100 percent dividends-received-deduction, such as :
• Subpart F income
• Global intangible low-taxed income
• Income invested in U.S. property
• Income subject to the transition-tax