Who can claim a deemed paid tax credit?
- A domestic “C” corporation that owns 10% or more of the voting stock and receives a dividend distribution from that corporation.
- A domestic “C” corporation that is a partner in a partnership and it owns stock of a foreign corporation.
What is a dividend?
- It is a distribution of property out of a foreign corporation’s earnings and profits.
- Code section 302 (d) stock redemption.
- Code section 1248 gain on the sale of stock of a controlled foreign corporation.
U.S citizens or resident aliens are not eligible for deemed paid foreign tax credit.
“S” corporations, partnerships, estates or trusts are not eligible for deemed paid foreign tax credit.
If “S” corporation structures its foreign operations as a branch or a partnership, its shareholders can claim a direct credit for foreign income taxes incurred by the foreign branch or partnership.
U.S citizens and resident aliens can take advantage of the 20% maximum U.S tax on qualified dividend income, which includes dividends received from foreign corporations that reside in countries that have entered into an income tax treaty with the United States.
Computing the deemed paid foreign tax credit
Pooling rule:
Determine the amount of foreign income taxes that are attributable to a foreign corporation’s dividend distribution.
If a foreign corporation distributes all of its after tax earnings, determination of foreign tax credit is not difficult. The foreign income taxes related to each year’s dividends are the foreign taxes paid in the taxable year.
If a corporation does not distribute all its earnings and profits each year it will lead to a tracing problem. We can resolve this issue in one of the two ways:
1 – Assume that dividend distribution is in chronological (a first in first out approach) or in a reverse chronological order (a last in first out approach).
2 – Pool undistributed earnings, profits and foreign income taxes and assume that a dividend distribution pulls out deemed paid taxes equal to the pool of foreign income taxes multiplied by the ratio of the dividend pool of undistributed earnings and profits.
Example:
USAco owns 100% of EURco (a foreign corporation). EURco’s earnings and profits, foreign income taxes, and dividend distributions for its first two years operations are as follows:
| Year | Pretax earnings | Foreign taxes | Income tax rate |
| 1 | $10 Million | $2 Million | 20% |
| 2 | $10 Million | $4 Million | 40% |
Earnings and profits year 1 = $8 Million and year 2 = $6 Million
Dividend distribution year 1 = Nil and year 2 = $3 Million
EURco (foreign corporation) pays dividends = $3 million to USAco in 2nd year.
Because the foreign tax rate on EURco’s earnings increased from 20% in year 1 to 40% in year 2, the last in first out method would pull out more foreign taxes than the pooling method.
Last in first out method:
Under this method the $3 million dividend represents distribution of 50% of EURco’s year 2 earnings and profits of $6 Million and, therefore, the dividend pulls out foreign income taxes of $2 million. (50% x $4 million of year 2 foreign income taxes)
Pooling method:
EURco has undistributed earnings and profits of $14 million ($ 8 million + $ 6 million) and foreign income taxes of $6 million ($2 million + $4 million). Therefore, under a pooling approach, the $3 million dividend pulls out foreign income taxes of roughly $1,285,714 (($6 million of foreign income taxes x ($3 million dividend / $14 million of earnings and profits))
Credit derived from lower tier corporations:
A domestic corporation that operates abroad through multiple tiers of foreign corporations can obtain a deemed paid foreign tax credit for taxes paid by lower tier foreign corporations (down six tiers). Both upper tier and lower tier foreign corporations have to be members of a qualified group.
What is a qualified group?
A qualified group consists of a first tier foreign corporation for which a domestic corporation may claim a deemed paid foreign tax credit, as well as any other foreign corporation if the domestic corporation owns at least 5% of the voting stock of the foreign corporation indirectly through the chain, the chain of foreign corporations are connected through stock ownership of at least 10% of their voting stock at each tier in the chain, and the lower tier foreign corporation is not below the sixth tier in the chain. Also, to be included in the qualified group, any foreign corporation below the third tier must be a controlled foreign corporation in which the domestic corporation is a U.S share holder.
Example:
USAco owns 100% of F1
F1 owns 40% of F2
F2 owns 10% of F3
F2 and F3 are foreign corporations.
USAco may claim a deemed foreign tax credit for the foreign income taxes paid by F2 because USAco owns at least 10% of F1 (100%), F1 owns at least 10% of F2 (40%), and USAco indirectly owns at least 5% of F2 (100% x 40% = 40%).
Even though F2 owns at least 10% of F3 (10%), because the indirect ownership by USAco of F3 is less than 5% (100% x 40% x 10% = 4%), USA co may not claim a deemed foreign tax credit for foreign income taxes paid by F3.
CFC and 10/50 company look through rules:
Look through rules apply to dividends received from either a CFC or a 10 / 50 company.
Look through rule also applies to deem paid credits.
If a domestic corporation structures a foreign manufacturing operations as a branch, the related income and foreign taxes would be assigned to general limitation income. In contrast, if a domestic corporation structures a manufacturing operation as a subsidiary, absent a look through rule, dividend distributions from the foreign manufacturing subsidiary would be assigned to passive limitation income.
To better equate the treatment of foreign branch and foreign subsidiary operations, dividends paid by a foreign corporation to a domestic corporation are allocated between passive income and general limitation income based on the ratio of the foreign corporation’s earnings and profits with in each category of income to the foreign corporation’s total earnings and profits.
Example:
FORco has earnings and profits = $1 Million
Attributable to general limitation = $900,000 (90%)
Attributable to passive limitation = $100,000 (10%)
The amount of deemed paid foreign taxes related to each separate category of income is calculated as below:
Post 1986 foreign income taxes related to category income x (Portion of dividend allocated to category of income / Post 1986 undistributed earnings related to category of income)
A domestic corporation must maintain separate pools of post 1986 undistributed earnings and post 1986 income taxes for passive limitation income and general limitation income with respect to any 10% or more owned foreign corporation.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.