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Conducting Business Abroad – The Indirect Foreign Tax Credit

Section 902 of the Internal Revenue Code Can Increase Your Bottom Line

If your business crosses an international border then you may already have experienced the byzantine tax complexity that arises.  Quite apart from the foreign tax obligations, because the U.S. insists on including your company’s worldwide income the risk of double taxation never seems to abate:  earn a dollar, pay tax as though you earned two.  The indirect tax credit is a big topic so let’s start at the beginning.  What the heck is it?

Authorized by section 902 of the Internal Revenue Code (the complete text is here, if you’re interested), the idea is ease the risk of double taxation by allowing certain corporations an offset to their U.S. for taxes by amounts other companies paid to or accrued in foreign countries.[1]  So, just who are those lucky companies?

First, the company claiming the §902 credit must be a “domestic corporation”, i.e., incorporated in the United States and not having made the S-election, either.  And second, the company claiming the credit must have received a “dividend” from a foreign corporation.

All these terms (domestic, dividend, foreign corporation) can give rise to tax disputes.  For example, it turns out that for these purposes “domestic” can include certain corporations formed in Canada or Mexico, provided they have agreed to file consolidated U.S. tax returns.  And whether the payment made to the domestic corporation was a “dividend” can be no easy thing to settle, either.  The law books are filled by cases trying to distinguish an ordinary dividend from an outright distribution.

Nor will just any foreign business entity do.  It may seem strange but not every country has the same definition of the term corporation, or even uses the term as we do.  Consequently, the particular foreign business paying the dividend must be of an entity type listed in IRS regulation 301.7701-2(b)(8).[2]  What’s more, to qualify for a §902 credit the U.S. company receiving the dividend must have owned at least 10% of the foreign corporation’s voting stock at the moment when the dividend was actually paid.[3]

It’s complicated, and every detail can be challenged, but if all goes well the domestic corporation gets a credit against its U.S. taxes for foreign taxes the foreign corporation paid.  That’s undeniably good for your bottom line, but calculating that credit can be a bear in itself.

To start, the amount of “creditable” foreign tax is calculated.  This means the foreign corporation must have already calculated its total post-1986 earnings and profits[4] (the “E&P pool”) and its total foreign income taxes paid (the “tax pool”).  The amount of foreign tax available for credit pursuant to §902, then, equals the amount of the paid dividend multiplied by the ratio of the tax pool to the E&P pool.

You’re not done yet, though.  Before you can claim the credit the Internal Revenue Code requires that you “gross up” the income received, i.e., the dividend, by the amount of creditable foreign taxes (the so-called “section 78 gross-up).

As a quick example, suppose qualifying FCo, at a time when it has a tax pool of $100 and an E&P pool of $1000, pays to qualifying USCo a $500 dividend.  Then the maximum amount of foreign taxes USCo can claim for credit would be $50 (i.e., 500 x 100/1000).  But to do so on its U.S. tax return USCo must recognize $550 of income rather than the $500 it actually received.

One last comment (actually, there are hundreds more but I’m stopping here):  Just like the §901 direct credit there is a maximum allowable amount for this credit, too.  So, in the example above, just because USCo above calculated a $50 credit doesn’t mean it will necessarily get to use the whole amount.

Maximizing your use of the Indirect Foreign Tax Credit requires serious planning and constant monitoring.  Whether you are presently conducting business across a border or thinking of expanding operations internationally, now is the time to make the tax considerations a part of your overall strategy.  Doing so will save you money and heartache, make your operations more efficient and profitable, and increase your chances of success.

 



[1] The direct tax credit (IRC §901) is the corresponding tax credit for individuals (also a pretty big topic).  To learn more about that check out this post.

[2] A second layer of complexity arises when a qualifying foreign entity elects to be considered another sort of entity for U.S. tax purposes, i.e., a foreign corporation can elect to be treated by the IRS as a partnership.

[3] This gets trickier still when the business structure is a tier of corporations, and the tax is paid by a lower tier while the dividend is passed up the chain to the U.S. parent.

[4] This is a term of art and the rules for calculating E&P go on for pages and pages.


This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.