In a further indication of the IRS’s continued focus on international tax issues, the tax agency updated an International Practice Unit (IPU) summarizing the calculation and recapture of foreign and domestic losses and their impact on the foreign tax credit.
Avoiding Double Taxation
The United States taxes U.S. persons on their worldwide income, including their foreign taxable income. The foreign tax credit generally prevents U.S. taxpayers from being taxed twice on that income — once by the foreign country where the income is earned, and again by the United States — by allowing U.S. taxpayers to reduce (on a dollar-for-dollar basis) the U.S. tax on that income by the foreign taxes they pay.
A limitation is imposed on the amount of foreign tax credits that can be claimed in a year in order to prevent taxpayers from claiming more in credits than the amount of U.S. tax that would have otherwise been imposed. The limit is generally calculated as: (foreign taxable income divided by worldwide taxable income) times pre-credit U.S. tax. It is calculated separately for various categories of foreign income.
In order to determine the U.S. and foreign taxable income in each separate category, business expenses, losses, and other deductions are allocated and apportioned to U.S.-source income and the separate categories of foreign source income. To the extent the allocations and apportionments create either a domestic or foreign loss in one or more separate categories, those losses are allocated against other net income, if any. When a net loss offsets net income of a different source or a different category of foreign taxable income, loss recapture rules are triggered.
A net loss in a separate category of foreign income is known as a separate limitation loss (SLL). This must offset net income in other foreign income categories (separate limitation income) on a pro rata basis before offsetting U.S. taxable income. When an SLL in one category offsets separate limitation income in another, an SLL account is created or increased.
An SLL account is recaptured when future foreign taxable income is produced in the same separate category as the SLL. Recapture occurs when this income gets recharacterized as foreign taxable income in the other separate category/categories in which the separate limitation income was previously offset by the SLL. The rules help to regulate the use of foreign tax credits among and within separate categories and generally ensure that credits aren’t used disproportionately.
Overall Foreign Loss
To the extent aggregate SLLs exceed aggregate separate limitation income, the excess (or overall foreign loss) may reduce the taxpayer’s taxable income in the United States. When an overall foreign loss offsets U.S. taxable income, a foreign loss account is created or increased.
A taxpayer with one of those accounts recaptures it by recharacterizing a portion of the future foreign taxable income, produced in the same separate category/categories that originally generated the overall foreign loss, as U.S. taxable income. As a result of that recapture, the foreign income of a taxpayer electing to credit foreign taxes is decreased by the recaptured amount for purposes of calculating the tax credit limit for that category, thus trimming the allowable foreign tax credit for the year. Recapture continues until the total foreign taxable income recharacterized as U.S. taxable income equals the amount in the overall foreign loss account.
The overall foreign loss recapture amount equals the lesser of the aggregate amount of maximum potential recapture in all such accounts or 50% of the taxpayer’s total foreign taxable income. The maximum potential recapture of a separate overall foreign loss account is equal to the lesser of the balance in the account or the foreign taxable income for the year in the same separate category.
If the aggregate amount of maximum potential recapture in all overall foreign loss accounts exceeds 50% of the total foreign taxable income, the income in each separate category with such a loss account is proportionately recharacterized as taxable U.S. income.
Overall Domestic Loss
A net U.S. source loss is known as an overall domestic loss. When this loss is allocated to reduce foreign taxable income, an account is created or increased.
These accounts are recaptured by recharacterizing future U.S. taxable income as foreign taxable income in the same category as the foreign income that was originally offset by the domestic loss. The domestic loss rules eliminate the double taxation of foreign taxable income over time. When U.S. taxable income is recharacterized as foreign taxable income in a later year, the recharacterization may generate a federal tax credit limitation that can absorb excess credits that may have resulted from the reduction of credit limitation in the earlier tax year, when the domestic loss offset foreign taxable income.
A taxpayer with an overall domestic loss account recaptures that account by recharacterizing a portion of the taxpayer’s U.S. taxable income for each following year as an amount that is the lesser of the aggregate balance of the taxpayer’s overall domestic loss accounts (to the extent not recaptured in prior years) or 50% of the taxpayer’s U.S. taxable income for such future year.
As a result of the domestic loss recapture, if the taxpayer elects to credit its foreign taxes, the taxpayer’s foreign income is increased by the recaptured amount for purposes of the computation of the federal tax credit limitation, thereby increasing the allowable amount of the credit for the year.
A Guide to Potential Audits
This International Practice Unit may help you prepare for a potential call from an IRS auditor asking to review your firm’s use of the foreign tax credit. Consult with your tax advisor with any questions or concerns you have.