General Income:
It includes all income other than passive income. It includes most of the foreign source active business profits of domestic corporations and their foreign subsidiaries.
Passive Income:
Passive income means:
- Dividends, interest, royalties, rents and annuities.
- Net gains from the disposition of property that produces dividend, interest, rent and royalty income.
- Net gain from commodity and foreign currency transactions.
- Income of a foreign passive investment company that has made a qualified electing fund election.
There are many exceptions to the general rules for determining passive income including the following items of income which are treated as general category income:
Highly taxed income:
Passive income does not include any “high taxed income”. Income is high taxed if the creditable foreign taxes related to the income exceed the product of the amount of that income multiplied by 35% in the case of a corporation or 39.6% in the case of an individual. This exception limits cross crediting of low tax and high tax passive income by removing any investment type income that gives rise to excess credits from the passive limitation income.
Controlled foreign corporation and 10/50 company look through rules:
A U.S shareholder allocates payments received from a controlled foreign corporation, including dividends, interest, rents and royalties, to the separate categories of income limitations based on the character of the controlled foreign corporation’s earnings. A look through rule also applies to dividends received form a non-controlled Code Section 902 corporation.
Active Rents and Royalties:
Passive income does not include rents and royalties that are derived in the active conduct of a trade or business such as royalties derived from intangible property of the type that the taxpayer regularly produces.
Export Financing Interest:
Passive income does not include any “export financing interest”.
Financial Services Income:
The term “financial services income” means income derived in the active conduct of a banking, insurance, financing or similar business by a person predominantly engaged in the active conduct of such a business. This provision allows financial services companies to engage in cross-crediting in the general limitation with respect to all of their financial services income, including both lightly-taxed investment type income and highly-taxed service income, fiduciary, investment banking and trust services.
Look Through Rules:
Look through rules apply to income received from a controlled foreign corporation, including dividends, interest, rents, royalties and Subpart F inclusions.
The specific look-through rule varies with the type of income derived from the CFC, as follows:
Dividends:
Dividends paid by a CFC to a taxpayer who is a U.S share holder of that CFC are allocated between passive limitations income and general limitation income based on the ratio of the CFC’s earnings and profits with in each category of income to the CFC’s total earnings and profits.
Rents and Royalties:
Rents and royalties paid by a CFC to a U.S shareholder of that CFC are allocated between passive limitations income and general limitation income based on the extent to which the related deduction is properly allocable to the CFC’s income in that category of income.
Interest:
Interest paid by a CFC to a U.S share holder of that CFC is treated as passive limitation income to the extent of the CFC’s foreign personal holding company income.
Subpart F inclusion:
A subpart F inclusion for an increase in a CFC’s earnings invested in U.S property is allocated between passive income and general limitation income using the same rule that applies to actual dividend distributions. In contrast, a Subpart F inclusion for Subpart F income is allocated between the separate categories of income based on the nature of the CFC’s taxable income that gave rise to the Subpart F inclusion.
Passive foreign investment company inclusion:
If the taxpayer is a U.S. shareholder of a CFC that also is a passive foreign investment company that has made a qualified electing fund election, then the look through rule that applies to Subpart F inclusions also applies to a qualified electing fund inclusion from that CFC.
10 / 50 companies:
Under the 10 / 50 company look through rule, a dividend is allocated between passive limitation income and general limitation income based on the ration of the 10/50 company’s total earnings and profits. Look through treatment does not apply to interest, rents and royalties received from a 10/50 company.
Partnerships:
A partner allocates its distributive share of partnership income between passive limitation income and general limitation income based on the character of the income at the partnership level. The rules applicable to partners in a partnership also apply to shareholders in an S corporation.
Allocating foreign income taxes:
In order to apply the separate category of income limitations, foreign income taxes also must be allocated between the passive and general income limitations. Foreign income taxes ae allocated to the category of income that includes the income on which the foreign taxes were imposed.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.