Sec. 904—Base Difference vs. Timing Difference for Foreign Taxes

The U.S. generally taxes the income of its citizens and residents on a worldwide basis. As a result, U.S. citizens and residents may earn income in a foreign jurisdiction that is subject to tax in both the jurisdiction in which it was earned and in the U.S. To avoid double taxation, Sec. 901 generally allows U.S. taxpayers to claim foreign tax credits (FTCs) on income taxes paid in foreign jurisdictions, subject to Sec. 904 limitations.

One purpose of these limitations is to prevent taxpayers from using a credit earned as the result of foreign tax paid on one category (or basket) of foreign income against U.S. tax owed on a different basket of foreign income. As a result, the FTC rules provide for several baskets; in calculating the amount of credit that can be claimed, a taxpayer must assign the foreign income taxes paid to the appropriate basket.

Base-Difference Rule

Taxpayers first must determine whether income taxed in a foreign jurisdiction is taxable in the U.S., and, if so, whether in the same year such income is taxed elsewhere. If an item of income is never subject to U.S. tax, Regs. Sec. 1.904-6(a)(1)(iv) defines the difference between the way the income is categorized by the foreign and U.S. jurisdictions as a "base" difference, and provides that the tax on the foreign income is to be treated as imposed for general limitation income (or general basket).

If, instead, the income is taxed both by the U.S. and the foreign jurisdiction, but in different tax years, Regs. Sec. 1.904-6(a)(1)(iv) defines the difference in the way the income is categorized as a "timing" difference, and provides that the tax paid on the item of foreign income is to be allocated to the appropriate separate category, as if the income were recognized in the U.S. in the year the foreign tax was imposed.

The definition of base difference in the regulations seems straightforward; some taxpayers may be using the base difference rule in situations such as those involving hybrid entities, in which a payment is characterized as income in a foreign jurisdiction, but as a nontaxable payment in the U.S.

Example: A U.S. parent, R, owns a foreign corporation F, for which a check-the-box election has been made, such that F is treated as a disregarded entity for U.S. tax purposes. F has $500 of general income and $500 of passive income and the foreign country imposes a 15% withholding tax on dividend payments to the U.S. When F pays a $100 dividend to R, the dividend would be a nontaxable event for U.S. tax purposes, but subject to $15 withholding tax for foreign purposes.

A literal reading of the regulations seems to suggest that this payment of foreign tax would be subject to the base-difference rule, because the dividend is never taxable in the U.S. Under this interpretation, the entire $15 withholding tax is allocated to the general basket.

However, the 1999 preamble to a regulation modifying the FTC passive basket "high-tax kickout" stated, "Treasury and the Service believe that a base difference exists within the meaning of 1.904-6(a)(1)(iv) only when a foreign country taxes items that the United States would never treat as taxable income, for example, gifts or life insurance proceeds" (TD 8805, 2/1/99). The inclusion of this language in the preamble may have been intended to signal the IRS's desire that the base-difference rule be narrowly interpreted and the timing-difference rule be broadly interpreted.

Possibly, some items of income not taxed by the U.S., such as the dividend payment in the example, may be considered by the Service to be outside the definition of the base-difference rule and, therefore, subject to the timing-difference rule. The theory in the example might be that F's earnings from which the dividend was paid are currently taxable in the U.S. Under this interpretation, because F's earnings are allocated equally between the general and passive baskets, the $15 withholding tax generally would be allocated $7.50 to the general basket and $7.50 to the passive basket.

Taxpayers should consider whether the literal language of Regs. Sec. 1.904-6(a)(1)(iv) is clear enough that income (such as in the example) falls within the definition of the base-difference rule. Arguably, a change to the language of the regulations needs to be made to have the timing difference apply in the example.

From Robert Huffman, J.D., and Alan Fischl, J.D., Washington, D.C.