Capital gains and losses receive a special treatment under U.S tax law. Individual capital gains and losses are netted. Non corporate taxpayer’s net capital gains get a preferred rate and are allowed limited deductibility of net capital losses.
Taxpayers must make various adjustments to limitations.
If a taxpayer includes the foreign source capital gain in the numerator of the foreign tax credit limitation, it can realize a second U.S tax benefit in the form of foreign tax credit. To prevent this a foreign source capital gain is excluded from the numerator of the foreign tax credit limitation to the extent it offsets a U.S source capital loss.
A distortion may arise if the tax rate applied to a U.S net long term capital gain is lower than the tax rate applied to the taxpayer’s ordinary income. Under current tax law there is a significant rate differential for individuals. When a capital gain rate differential exists, the attribution of the pre-credit U.S tax to foreign source taxable income for purpose of computing the foreign tax credit limitation will be based on the “average” rate of U.S tax on both ordinary income and the net capital gain.
This is advantageous when the long term capital gain is from foreign sources but it is disadvantageous if the long term capital gain is from U.S sources.
To prevent this kind of distortion a taxpayer that has a capital gain rate differential must reduce the numerator of the foreign tax credit limitation fraction by a portion of any foreign source capital gain net income.
The taxpayer must also reduce the denominator of the limitation by a portion of the overall capital gain net income.
The adjustment due to capital gain rate differential should only impact the foreign tax credit limitation for U.S individuals receiving foreign source dividends in unique situations.
A capital gain rate differential can create a distortion when a taxpayer is a net long term capital gain position nets a foreign source capital loss against a U.S source long term capital gain. The effect of the foreign source capital loss on the foreign tax credit limitation is based on the average rate of U.S tax on both ordinary income and the net long term capital gain. To prevent this a tax payer who has a capital gain rate differential can increase the numerator of the foreign tax credit limitation fraction by a portion of the foreign source capital loss.
Losses:
For purposes of computing the taxpayer’s foreign tax credit limitation, special rules apply when a taxpayer’s business activity gives rise to a net loss.
Overall Foreign Losses:
Overall foreign losses arise in a tax year in which the deduction properly allocated and apportioned to foreign source gross income exceed the amount of such income. Cases of overall foreign loss include losses on export sale of inventory, the flow through of foreign branch or partnership losses and the allocation and apportionment of deductions to foreign source gross income.
A taxpayer who sustains an OFL must in each succeeding year, recapture all U.S source income the less of:
- 50% (or a larger percentage if the taxpayer so selects) of its foreign source taxable income for that succeeding year, or
- The amount of the OFL that has not yet been recaptured.
Separate Limitation Losses:
Separate foreign tax credit limitations are computed for passive limitation income and general limitation income. A separate limitation loss arises in a year that the deductions properly allocated and apportioned to the foreign – source gross income with in one of the limitations exceed the amount of such income.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.