Editor: Frank J. O’Connell Jr., CPA, Esq.
Foreign Income & Taxpayers
An incentive program offered by a foreign government or jurisdiction often is a major determining factor in where a multinational chooses to expand its footprint. These incentive packages frequently come in a combination of infrastructure investments, subsidies, grants, tax credits, and job training programs. Depending upon its industry and line of business, an incentive program may even be the sole reason that a company invests and operates in a particular jurisdiction. These incentives can create a significant financial buoy to a company starting up in a given market and remain a tremendous competitive advantage far into the future. Although companies reap great benefits from local incentives, many U.S. multinationals operating in foreign jurisdictions via subsidiary corporations may be shortchanging themselves when they account for the effect of local incentives on available foreign tax credits in the United States.
As discussed below, a common technique for distributing the benefit offered through incentive programs is to offset or credit income taxes due in the foreign country offering the incentive. Depending upon the nature of the credit, the way it is calculated, and the manner in which it is provided to the intended beneficiaries, the U.S. taxpayer may not be required to reduce the foreign taxes against which the incentive credit is applied. This can prove to be a major windfall for U.S. taxpayers that would then be able to take a credit for these taxes rather than be forced to reduce the claim for foreign tax credits by the amount of the incentive.
Sec. 901 allows a taxpayer to credit certain income taxes paid to a foreign country or possession of the United States. Also, Secs. 902 and 960 provide that certain domestic corporate shareholders are deemed to have paid a ratable portion of the foreign income taxes of a foreign corporation when that foreign corporation distributes a dividend or, in the case of a controlled foreign corporation, requires an inclusion in gross income under Sec. 951(a). An issue arises when the local tax jurisdiction uses a tax credit as a means to administer the payment of incentives, because the final tax liability is now lessened by the amount of the credit. In effect, the offset forces the taxpayer to reduce the amount of foreign taxes equal to the incentive. However, under the Sec. 901 foreign tax credit rules, not all local tax credits reduce the amount of foreign taxes paid.
While the method of the remittance or delivery of the incentive program benefits varies, a popular manner of payment is an offset of country and/or local income taxes. This method is preferred for many reasons because it not only eases the burden of administering the payment, but it also reduces tax avoidance by creating a de facto withholding instrument. The offset procedure also can reduce the overall cost of the incentive program by reducing the government’s outlay of cash. Although this practice often benefits the foreign government or taxing jurisdiction, it causes a lot of uncertainty on the U.S. side as to what is treated as the actual amount of foreign taxes paid under Sec. 901.
For purposes of determining a U.S. foreign tax credit, the treatment of foreign income tax subject to a reduction by refund, credit, or subsidy is addressed in Regs. Secs. 1.901-2(e)(2) and (3). Regs. Sec. 1.901-2(e)(2) provides, in part, that an amount is not a foreign tax to the extent it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven. Regs. Sec. 1.901-2(e)(3) further provides that foreign taxes available for credit in the United States do not include any tax used, directly or indirectly, to provide a subsidy to the taxpayer when the subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used to compute the amount of the tax. To prevent a reduction in foreign tax in the amount of an incentive offset or credit administered through the tax system, the affected taxpayer must demonstrate that the credit itself is not actually a credit or refund within the meaning of Regs. Sec. 1.901-2(e)(2), nor is it a subsidy for purposes of Regs. Sec. 1.901-2(e)(3). The key is to establish that, while the credit may reduce the overall foreign liability mechanically, it does so only as a means of administrative convenience and not necessarily because the credit itself is in any way linked to the calculation of the income taxes due.
Any analysis of foreign tax incentives and their effect on foreign taxes paid centers on the parameters set forth in Regs. Secs. 1.901-2(e)(2) and (3). Perhaps the leading guidance in the area is GCM 39617 (affirmed in Rev. Rul. 86-134), addressing whether a Dutch investment incentive program known as WIR premiums reduced taxes paid to the Dutch government. Nearly every item of guidance related to the effect of refundable tax credits on the U.S. foreign tax credit issued by the IRS since GCM 39617 draws from its conclusions and uses its analysis as a baseline for determining whether an incentive granted through means of a tax credit reduces foreign taxes paid for purposes of Sec. 901.
In the GCM, the IRS discusses the treatment of WIR premiums granted by the Netherlands both under law in effect before May 1986 and as amended after April 1986. The WIR premiums were determined as a percentage of the investment in qualifying assets within the Netherlands. Before 1986, a taxpayer would receive the benefit of the premiums as an offset against income tax liability for the year. To the extent the premiums exceeded the liability, they were refunded in cash to the taxpayer. Under the new law, the post-1986 premiums would still offset income tax liability, but then could be carried back or forward only to offset past or future liabilities. Any excess remaining after a carryback or carryforward could not be refunded to the taxpayer.
The IRS determined that the premiums under the law in effect before 1986 should not be treated as reducing Netherlands income taxes paid because the taxpayer received the full amount of the WIR premium without regard to the amount of Netherlands income tax liability. Conversely, the IRS maintained that the post-1986 premiums should be treated as a refund or credit under Regs. Sec. 1.901-2(e)(2) because the taxpayer could receive only the benefit of the nonrefundable WIR premium as a reduction in income tax liability, essentially forcing the premiums to be characterized as a credit that fell squarely within the language of Regs. Sec. 1.901-2(e)(2).
The next hurdle the pre-1986 refundable premiums had to clear was the subsidy test of Regs. Sec. 1.901-2(e)(3). This provision addresses whether a subsidy offered to the taxpayer must be treated as a reduction in foreign income taxes. The IRS determined that, although the pre-1986 premiums were in fact a subsidy, they were not the kind of subsidy described in Regs. Sec. 1.901-2(e)(3) because the premiums were not determined, directly or indirectly, by reference to the amount of income tax, or the base used to compute the income tax, imposed by the Netherlands (see Regs. Sec. 1.901-2(e)(3)(i)). As noted above, the WIR premium was calculated based upon a percentage of qualifying assets purchased by the taxpayer and, therefore, was determined independently of the tax base. The fact that it offset income taxes due was merely a function of payment of the premium to the taxpayer, and it did not affect the amount of the subsidy the taxpayer received.
Broadly speaking, GCM 39617 stands for the premise that the key distinction between a local tax credit that reduces foreign tax and one that does not hinges upon two pivotal factors: (1) the ability to use all incentive benefits regardless of any tax liability; and (2) the separation of the incentives from the tax base defined under local tax law.
The first factor may be restated as a question. Even when a payment is generally offset against taxes due, does the taxpayer have the option of receiving the full benefit of the incentive via a refund or cash payment, or is the incentive available only through an offset of income taxes either carried back or carried forward indefinitely? The GCM makes this criterion very clear when it concludes that the pre-1986 premiums, which refunded excess credits directly to the taxpayer, did not constitute a credit that reduced foreign taxes paid because the taxpayer received the full benefit of the premiums without regard to income taxes due. The fact that the premiums were used to offset taxes due is interpreted as a means of payment if the taxpayer will receive the entire refund in one way or another. On the other hand, when an incentive credit is available only through an offset of income taxes and any excess must be carried into another year to offset income taxes, similar to the post-1986 WIR premiums, the incentive credit is viewed as a reduction of foreign taxes paid under Regs. Sec. 1.901-2(e)(2).
With regard to the ability to access an incentive via cash refunds, the IRS has opined that the taxpayer does not necessarily have to receive the refund immediately in the current year to escape the reduction requirement of Regs. Sec. 1.901-2(e)(2). There are instances when an incentive credit has been required to offset current income tax due initially and then must be carried forward for a set period of years (see TAM 200146001). After that time period, any excess credits remaining were to be refunded in cash. The IRS maintained that this deferred refund mechanism still allowed the incentive credit to fall outside of the definition of a credit under Regs. Sec. 1.901-2(e)(2) and thus did not reduce foreign taxes paid.
Much of taxpayers’ reluctance to pursue full foreign tax credits in some situations likely stems from Example (2) in Regs. Sec. 1.901-2(e)(2), which can be misleading and is often inaccurately applied. In that example, a taxpayer has an initial tax liability in a foreign country of 100u. The tax liability is then reduced by an investment credit of 15u and a credit for charitable contributions of 5u. The example then states that the taxpayer’s income tax paid for purposes of Sec. 901 is 80u. This oversimplified example may incorrectly lead taxpayers to believe that whenever a credit offsets taxes due in a foreign country, it automatically reduces total foreign taxes paid for purpose of Secs. 901 and 902. As demonstrated in GCM 39617, however, this blanket reduction rule is overly restrictive. The example in the regulations fails to address a situation in which the amount of an investment credit first offsets the tax liability but then is refunded, partially or wholly, in cash to the taxpayer. This failure may result in taxpayers’ frequently looking no further than this seemingly simple example.
The second critical determining factor is the question of whether the incentive or credit is determined in a manner independent of the tax base or in reference to the tax base. As the GCM illustrates, an incentive credit can still be considered a subsidy without reducing foreign taxes paid as long as it is not directly or indirectly determined as a function of, or in reference to, the foreign income tax liability or base. The WIR premiums were calculated as a percentage of the cost of qualifying business assets. An example in which a contested credit has failed the subsidy test of Regs. Sec. 1.901-2(e)(3) was the subsidy provided by the Virgin Islands government in Rev. Rul. 69-433. That subsidy was calculated as a fixed percentage of the taxpayer’s Virgin Islands tax liability.
In summary, it is important not only to identify local country tax credits that a company or client may be receiving but also to gain a basic understanding of how those credits are generated and the rules surrounding the refund procedure when the credit exceeds the foreign tax liability. For new or existing clients, it is often worthwhile to request a copy of local country tax returns the client or its subsidiaries filed in foreign countries and review the entire calculation, rather than merely pulling the final liability amount to ascertain whether the final liability was reduced or offset by tax credits. If the final liability was in fact reduced by credits, further investigation may be merited to determine how the credits should be treated under the analysis outlined above. Identifying the existence of tax credits that may have unnecessarily reduced foreign taxes paid can serve as a great opportunity to tap unused credits and ultimately lower a taxpayer’s final U.S. tax liability. This exercise is especially worthwhile given the extended period (10 years) that is available to taxpayers under Sec. 6511(d)(3) to amend tax returns to claim additional foreign tax credits.
Frank J. O’Connell Jr. is a partner with Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.