FTC Baskets Reduced to Two

Income earned by U.S. companies doing business abroad is susceptible to double taxationonce by the country in which earned, and again by the U.S. Foreign tax credits (FTCs) can prevent double taxation, but they have a number of restrictions. One of these is the segregation of FTC baskets, under Sec. 904(d): the foreign taxes in one basket cannot be used to reduce Federal income tax on the income in another basket.

New Law

The American Jobs Creation Act of 2004 (AJCA) favorably changed the FTC basket regime, by reducing the number of FTC limitation categories from nine to two; see Sec. 904(d)(1), as amended by AJCA Section 404(a). The two remaining baskets are:

1. Passive income and

2. General category income.

This provision is applicable for tax years beginning after 2006. A transition rule will apply the two-basket treatment to taxes carried over from any tax year beginning before 2007, to the tax year beginning after 2006, unless regulations dictate otherwise; see AJCA Section 404(f)(5), amending Sec. 904(d)(2)(K)(i).

Thus, all FTC limitation categories will be reclassified into either the passive or general limitation category. For purposes of maximizing the FTC limitation, the shrinkage in categories will make it more important to analyze not only the FTC passive limitation category and its contents, but also to search out exceptions to this category. The ultimate goal is passive limitation minimization and general limitation maximization.

Definition

For purposes of the FTC limitation, passive income includes the following components of foreign personal holding company (FPHC) income, under Secs. 904(d)(2)(A)(i) and 954(c)(1), as amended by AJCA Sections 404(b) and 413(b)(2):

1. Dividends;

2. Interest;

3. Rents and royalties;

4. Annuities;

5. Net gain from certain property transactions;

6. Net income equivalent to interest;

7. Income from notional principal contracts;

8. Payments in lieu of dividends;

9. Payments in lieu of dividends from certain securities loans; and

10. Gain on a sale or exchange of stock in excess of the amount treated as a dividend.

The passive basket contains three major exceptions that reclassify earned income into the general limitation basket. Income falling into one of the following three categories falls under these exceptions; see post-AJCA Secs. 904(d)(2)(B)(iii) and 954(c)(2):

1. Export financing interest;

2. High-taxed income (as defined in Sec. 904(d)(2)(F); and

3. Active rents or royalties received from an unrelated person.

Export Financing Interest

For purposes of the separate FTC limitation for passive income, Sec. 904(d)(2)(G) defines export financing interest as any interest derived from financing the sale or other disposition of certain property for use or consumption outside the U.S. This includes property manufactured, produced, grown or extracted in the U.S. by the taxpayer or a related person, if not more than 50% of its fair market value is attributable to products imported into the U.S.

High-Taxed Income

Under Sec. 904(d)(2)(F), income that attracts a relatively high foreign tax (high-taxed income) is not passive income for purposes of the separate FTC limitation on passive income. Thus, such income is included in the overall FTC limitation; any taxes on it are deemed related to general limitation income under the tax allocation rules. A rule, known as the high-tax kick-out, ensures that separate limitation passive income is segregated from relatively high-taxed income, and avoids substantial averaging of foreign taxes within the passive income limitation category. High-taxed income is at least 90% of the maximum U.S. top rate of 35%, or 31.5%.

Active Rents or Royalties

Passive income does not include rents or royalties derived in the active conduct of a trade or business, if received from an unrelated person, or a related person as described in Sec. 954(c)(3). Whether a rent or royalty is active is determined under a modified facts-and-circumstances test that applies to FPHC income, under Sec. 954(c)(2), as modified by AJCA Sections 414(c) and 415(b). The modification allows rents and royalties to be treated as active if the relevant requirements are satisfied by any member of the corporations affiliated group (defined by including only U.S. corporations and controlled foreign corporations, in which U.S. members of the affiliated group own, directly or indirectly, at least 80% of the total voting power and value of the stock, including indirect ownership).

Conclusion

After the AJCA, taxpayers must continue to be vigilant over FTC limitation management. The passive basket must be monitored to ensure all of its exceptions have been investigated; when possible, all available planning to recharacterize passive limitation income should be used to maximize the cross-crediting of foreign taxes.

From Bill Zink, CPA, Washington, DC