Indirect Foreign Tax Credit

1. Indirect Foreign Tax Credit • Recall that the foreign tax credit is available to US persons for foreign income taxes paid on foreign source income • What if a US person owns an interest in a foreign corporation? • The foreign corporation will pay foreign taxes but not qualify for a FTC (since not a US person and not paying US tax) • When the foreign corporation pays a dividend to the US shareholder, such dividend is paid out of after (foreign) tax earnings!

2. Deemed Paid Foreign Tax Credit • No dividends received deduction typically allowed for foreign source dividends • A US corporation receiving dividends from foreign corporations meeting certain ownership requirements • Recognizes dividend income equal to the net dividend received plus foreign taxes paid by the foreign corporation on the income from which the dividend is distributed • Claims a deemed paid credit for the above tax amounts, subject to FTC limitations

3. Dividend Gross-up and Deemed Paid Foreign Taxes Foreign taxes Post-1986 Dividend paid bydeemed = taxes of foreign X foreign corporation paid corporation Post-1986 undistributed earnings of foreign corporation Total dividend = Dividend + Foreign taxesincome paid deemed paid

4. Example 1: Deemed Paid Foreign Taxes • Home Corporation receives a dividend of $1 million from Away, Inc., a 100% owned foreign corporation. Prior to the dividend payment, Away had $5 million of undistributed post-1986 earnings and had paid $2 million of foreign taxes. Compute Home’s deemed paid foreign taxes and total dividend income attributable to the payment from Away.

5. Ownership Requirements • Not all foreign dividends bring with them ‘deemed paid’ foreign taxes • US corporation must own at least 10% of the voting stock of the foreign corporation • For lower tier subsidiaries • Must be connected through a chain of ownership in which each tier owns at least 10% of the lower tier • US parent’s indirect ownership must be at least 5% • In 4th, 5th, and 6th tiers, must be a CFC of which the US parent is a ‘US shareholder’ • No deemed paid taxes beyond the 6th tier

6. Example 2: Ownership and Deemed Paid Foreign Taxes • USA Inc., a US corporation, owns the following voting stock interests in foreign corporations: • 50% interest in F1 • 20% interest in F2 • 100% interest in F3 • F1 owns 25% of F4, F2 owns 50% of F5 and 20% of F6, and F3 owns 80% of F7 • From which foreign corporations do deemed paid taxes flow through to USA?

7. Dividend Baskets • Depending on the level of a US corporation’s ownership of a foreign corporation, 3 different basket rules may apply for purposes of the FTC limitation • Passive income basket • 10/50 basket(s) • Look-through • For individuals, only the passive income and look-through basket rules apply

8. Dividend Baskets continued • Passive income basket • Dividends from foreign corporations not meeting the ownership requirements for deemed paid foreign taxes • 10/50 baskets • Dividends from corporations with greater than 10% ownership not qualifying as ‘controlled foreign corporations’ • Dividends from each 10/50 corporation are a separate basket for purposes of the FTC limitation

9. Dividend Baskets continued • Look-through • Dividends from ‘controlled foreign corporations’ are placed in baskets by looking through to the underlying income character of the paying corporation • Controlled foreign corporation (CFC) • Foreign corporation in which ‘US shareholders’ own more than 50% of voting power or value of stock • ‘US shareholder’ is a US person owning 10% or more of voting power or value

10. Example 3: Dividend Baskets • Refer to example 2 • Determine which of the corporations in which USA owns an interest are considered ‘controlled foreign corporations’ • For each corporation in which USA owns an interest, determine the dividend basket that applies in sourcing dividend payments • How would your basket designations change if USA where an individual rather than a corporation?

11. Example 4: CFC and Deferral of US Taxation • Micro Inc. is a US corporation conducting business abroad. Micro earned $1 million of foreign source income and $3 million of US source income. It paid $200,000 of foreign income taxes. • If Micro conducts business abroad through a branch office, calculate its US tax liability after FTC and total worldwide tax burden. • How would your answers change if Micro conducts business abroad using a foreign subsidiary?

12. Example 4 continued • Suppose that Micro reinvests its foreign earnings (after tax) for 10 years. During this period, its earnings grow at a 10% rate per year. At the end of 10 years, it repatriates all of its after (foreign) tax foreign earnings. Quantify the value of the deferral of US taxation achieved through the use of a foreign corporation.

13. Subpart F and Limits on Deferral • Subpart F imposes current taxation on certain tax haven income of CFCs • US shareholders of CFCs are taxed as though such income were currently repatriated • Two targeted groups of CFCs: • Foreign personal holding companies • Foreign base companies

14. Foreign Personal Holding Companies (FPHC) • Definition: Foreign corporation in which • More than 50% of voting power or value of stock is owned directly or indirectly by 5 or fewer US individuals, and • At least 60% of gross income is ‘foreign personal holding company income’ • Passive investment income • Securities and commodities gains • Income from personal services performed by 25% or greater shareholders

15. Example 5: FPHC • Ed, a US citizen with a 40% marginal tax rate, owns 100% of the stock of Comet Inc., a foreign corporation. Comet earned $200,000 of interest and dividend income, recognized $50,000 of securities gains, had active business income of $150,000, and paid $50,000 of foreign income tax (all related to its business income). • Is Comet a FPHC? • What are the US tax implications for Ed and Comet?

16. Foreign Base Companies • Concept: Tax haven base for recognizing profit that has been artificially shifted there from the jurisdiction of the underlying economic activity generating that profit • Foreign Base Company Income: • Foreign personal holding company income • Foreign base company sales income • Foreign base company services income • Foreign base company shipping income • Foreign base company oil related income

17. Foreign Base Company Sales Income • Income from the sale of personal property between related persons, where the property is • Manufactured, produced, grown or extracted outside the country in which the CFC is organized • For use, consumption, or disposition outside that country • Substantial value added in the CFC’s country removes the income from this category

18. Foreign Base Company Services Income • Income from services performed for or on behalf of a related person outside the country in which the CFC is organized • Does not include services actually performed in the CFC’s country • Does not include services related to the sale of property produced by the CFC

19. Subpart F Income and the FTC • Income subject to Subpart F is considered constructively repatriated • Subject to ‘dividend gross up’ and ‘deemed paid foreign tax’ rules • Look-through rules apply in determining income sourcing for FTC basket limitations • Some types of Subpart F income (passive income, shipping income) are also subject to separate baskets for FTC purposes

20. Example 6: Impact of Subpart F on Deferral • Refer to Example 4, in which Micro uses a foreign subsidiary to conduct operations earning $1 million and paying $200,000 of foreign tax. Micro has $3 million of US source income. • If $600,000 of the foreign subsidiary’s earnings are foreign base company sales income, calculate Micro’s US tax liability after FTC and total worldwide tax burden • How does Subpart F impact the long-term value to Micro of using a foreign subsidiary?

21. Example 7: FPHC versus CFC with FPHC Income • Refer to Example 5, in which Ed owns 100% of Comet. How would your conclusions change if Comet’s owner were Ed Inc., a US corporation?