International Taxation – Outbound
A U.S. taxpayer working in a foreign country must report any income earned and pay applicable U.S. taxes. However, that taxable income can be reduced through:
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Foreign Tax Credit
The U.S. tax system includes a foreign tax credit to mitigate the possibility of double taxation. This credit, which is at the heart of U.S. outbound taxation, reduces the U.S. taxes on income earned outside the country that has been subjected to a tax in the foreign jurisdiction. In effect, the foreign tax credit allows for a full offset for any foreign taxes paid, up to the level of tax that would be assessed on that same income in the United States.
Limitations and Applicability
The foreign tax credit [IRC Section 901(a)] allows U.S. taxpayers to reduce U.S. tax paid on foreign income by the amount of foreign taxes paid on that income. Generally, taxpayers are prevented from using foreign tax credits to reduce U.S. tax liability on income from sources within the United States. A primary area of concern with respect to the foreign tax credit relates to the classification of income. Determining whether the income is classified as foreign or U.S.-sourced will impact the foreign tax credit limitation and the available credit.
The amount of the foreign tax credit that can be applied against U.S. tax liability is subject to limitation under the foreign tax credit limitation [IRC Section 904]. The credit against U.S. income tax is allowed for any income, war profits and excess profits taxes paid or accrued by the taxpayer to a foreign country or United States possession during the tax year. This includes taxes paid in lieu of income, war profits and excess profits taxes [IRC Section 903]. The credit may not be claimed against any U.S. tax, such as the accumulated income tax, that is not treated as a regular income tax. The credit is nonrefundable.
A foreign tax credit may be claimed for taxes paid directly, as well as indirectly. A domestic corporation that owns at least 10% of the voting stock of a foreign corporation from which it receives dividends is deemed to have paid a percentage of the foreign corporation’s foreign taxes. Additionally, domestic corporations (or individuals electing to be taxed at corporate rates) that are 10% shareholders in foreign corporations are entitled to claim the foreign tax credit with respect to amounts attributable to the foreign corporation’s earnings and profits that are included in gross income.
Note, that as an alternative to claiming the credit, a taxpayer may choose to deduct the foreign taxes paid or accrued.
Deduction vs. Credit
The taxpayer can choose whether to take a deduction or claim a credit. Generally, it is more advantageous to credit qualified foreign taxes than to deduct them because the credit, which is taken against a taxpayer’s U.S. tax liability, reduces U.S. income taxes on a dollar-for-dollar basis. In contrast, a deduction merely reduces the taxpayer’s income subject to tax.
Further, the foreign tax credit can be claimed by an individual taxpayer regardless of whether the taxpayer itemizes deductions. Individual taxpayers who deduct foreign taxes must claim the taxes as an itemized deduction on Schedule A, Form 1040. Also, a taxpayer may not deduct foreign taxes paid on income exempt from U.S. tax; whereas, within certain limitations, this restriction does not apply to taxes credited.
In certain circumstances, particularly with lower-level adjusted gross income, there will be cases where a deduction yields a more advantageous tax position. No portion of the taxes subject to the credit is allowable as a deduction from gross income for the tax year or any succeeding tax year.
Taxpayer Eligibility
Taxpayers entitled to claim the foreign tax credit, with respect to taxes paid or accrued to foreign countries and U.S. possessions, generally include:
- U.S. citizens, whether residents or nonresidents;
- Domestic corporations;
- Alien residents of the United States; and
- Alien individuals who are bona fide residents of Puerto Rico for the entire tax year.
Note, that any of these potential claimants may claim the foreign tax credit for that taxpayer’s share of taxes of a partnership in which the taxpayer is a partner, or of an estate or trust, in which the claimant is a beneficiary. For purposes of the foreign tax credit, an S corporation is treated as a partnership, with its shareholders treated as partners. Accordingly, the foreign taxes paid by an S corporation will pass through to its shareholders who may claim the foreign tax credit. An S corporation is ineligible for the foreign tax credit with respect to foreign taxes paid by a foreign corporation in which the S corporation is a shareholder.
Creditable Taxes
When determining the possible benefits of utilizing the foreign tax credit, it is important to fully understand which taxes assessed by the foreign country are considered (creditable) in calculating the foreign tax credit. Foreign taxes that are creditable are generally those that are based on net gain. The term “foreign tax” is mainly defined by Treasury regulations. However, even with this detailed information, it can be exceedingly difficult to immediately ascertain which foreign taxes fall within this definition.
The IRS has issued a number of specific rulings to address which foreign taxes qualify, and other limitations may apply. Tax treaties with other countries should also be considered. It is best to consult your GYF Tax Executive for assistance with determining which taxes are creditable.
Year of the Credit
The foreign tax credit may ordinarily be taken either in the year when the taxes are accrued or in the year in which they were paid, depending upon whether the taxpayer is on the accrual or the cash basis. However, a cash-basis taxpayer may elect to claim the credit on an accrual basis. Unused credits, which cannot be claimed for a tax year because of the limitations on claiming the foreign tax credit, may be carried back to the two preceding years and forward to the five succeeding years. Further, a taxpayer may elect the foreign tax credit at any time during the 10-year period of limitations.
One great resource for learning more about the foreign tax credit and the many nuances associated with its proper determination is IRS Publication 514
Foreign Earned Income Exclusion
The foreign earned income exclusion allows a U.S. citizen or resident to exclude, from his or her U.S. taxable income, a certain portion of their income that is earned in a foreign country. Thus, it is a mechanism by which to decrease the amount of income that would otherwise be subjected to double taxation. The amount of available exclusion is adjusted each year for inflation. Additionally, while housing cost amounts are included in an employee’s foreign earned income, an additional housing cost allowance exclusion, which is part of the earned income exclusion, may be claimed.
Qualifying for the Exclusion
Before any individual takes advantage of the foreign earned income exclusion, they must ensure they have a “tax home” in a foreign country and meet the qualifications and attributes as set forth under either the bona fide residence or physical presence test. Normally, one’s tax home can easily be identified as his or her principal place of business. If a taxpayer has no principal place of business, his or her normal place of abode is controlling.
The bona fide residence test is satisfied when a taxpayer can establish that he or she resided in a foreign country for an uninterrupted period that includes an entire tax year. Since taxpayers file returns on a calendar-year basis, any individual who moved to a foreign country during the middle of year XXX1 would then have to wait until the end of year XXX2 to qualify under this test.
A taxpayer would also qualify for the foreign earned income exclusion if he or she passed the physical presence test. This test can be met by being physically present in a foreign country for at least 330 days during the 12 consecutive months. Provided a taxpayer meets all of the requisite conditions, he or she will qualify for the foreign earned income exclusion.
Determining the Exclusion Amount
Once a taxpayer has qualified for the foreign earned income exclusion, it is time to crunch the numbers to determine the actual exclusion amount. By and large, the exclusion calculation starts by first assessing how many days are in the tax year of the period where the taxpayer meets the 330-day test. This number is divided by 365, and multiplied by the exclusion limit. For a taxpayer who meets the qualifications based on the bona fide residence test, the exclusion limitation would be at its maximum. A taxpayer would only get the benefit for his or her actual foreign earned income up to the exclusion limitation. Thus, the exclusion is the lesser of the actual foreign earned income or the exclusion limitation amount.
If the individual claims the foreign earned income exclusion, a foreign tax credit may be claimed for the foreign taxes paid or accrued on income that is not excluded. In this situation, foreign taxes available for the foreign income tax credit must be reduced by taxes paid or accrued on income that is excluded from U.S.-sourced income under the foreign earned income exclusion or the foreign housing exclusion.
To determine the amount of foreign taxes that are allocable to the excluded income, the amount of foreign taxes paid or accrued on the excluded income is multiplied by a limiting fraction. The numerator of the limiting fraction is the total of all foreign earned income and housing amounts that are excluded from income along with the housing exclusions, minus the definitely-related and properly apportioned expenses, excluding the foreign housing deduction. The denominator of the limiting fraction is total foreign earned income, minus all deductible expenses allocated to the income, including the foreign housing deduction.
Additional guidance can be found in IRS Publication 54
Classification of Income
A primary area of concern for both U.S. citizens and resident aliens regarding the classification of income relates to the foreign tax credit. Determining whether the income is classified as foreign or U.S.-sourced will impact the foreign tax credit limitation and the available credit.
A major issue regarding income classification is the lack of clarity and global acceptance regarding how to determine the proper source of a stream of income. One country’s tax regime may not treat a transaction in the same manner as another. The sections below detail various characters of income and items for consideration in determining their sources for U.S. tax purposes.
Interest
Interest payments originate from the individual or the underlying business activity of the entity which remits payment. Payments made by nonresident individuals of the United States, by default under IRC Section 861(a) (1), are sourced to the United States. Foreign branches of U.S. banks make foreign-sourced interest payments. Somewhat more-difficult to determine is the source of income from partnerships that remit interest payments.
The rules for determining the proper situs of the source for these entities changed in 2004. Prior to that time, the analysis was relatively simple. If the partnership was, in fact, engaged in a U.S. trade or business, it paid U.S.-sourced interest. Conversely, if the partnership was not engaged in a U.S. trade or business, the source was deemed to be foreign. In 2004, the rules for partnership interest sourcing were modified so that all foreign partnerships made foreign-sourced interest payments if their business operations were predominantly engaged outside of the United States, and the income was not allocable to income which was effectively connected to U.S. operations. In theory, these rules put partnerships and corporations on a semi-equal playing field.
From a corporate standpoint, the basic idea sources interest payments to the place of incorporation, subject to a few exceptions including obligations issued before August 10, 2010. Under this special provision, interest received from a resident alien was considered to be foreign-sourced if 80% of the domestic corporation’s gross income was from foreign trades or businesses. These types of domestic corporations are often referred to as “80/20 corporations” because the remaining 20% of activity was related to U.S. activity.
Dividends
Dividend payments follow the same general principle as interest payments where the situs of the corporation is controlling, absent an exception. Foreign corporations that issue a dividend receive U.S.-sourcing if 25% or more of the gross income for the corporation in the three preceding years to declaring the dividend is effectively-connected income with the United States. In addition, the amount of the U.S.-sourced dividend is adjusted based upon the ratio of U.S.-sourced income to the corporation’s entire income for the same period.
For example, if a foreign corporation issued a $500 dividend, and 50% of its previous three years’ income was 50% effectively connected to the United States, the original $500 dividend would be sourced one half to the United States.
Compensation for Personal Services
The general rule sources income to the location where the services were performed; however, the problem lies with employees who work from all around the globe, which can lead to confusion surrounding the performance location.
As always, there are certain exceptions to the general rules. A 90-day rule excludes certain compensation from the breadth of the U.S. tax system when the services are actually performed in the United States. This rule considers all compensation earned by a foreign person to be foreign-sourced if: (1) the individual is present for 90 days or fewer in the United States during the current taxable period, (2) the services are for a foreign person not engaged in a trade or business in the United States, and (3) the total compensation does not exceed $3,000. Practically speaking, the 90-day rule is never utilized as the dollar threshold is considerably low.
In determining the performance location and the proper allocation method when services are performed in multiple locations, the Treasury regulations allocate compensation on the basis of time. In contrast, other employee benefits are determined on the basis of geography. Housing, transportation and education benefits are determined based upon the employer’s business location. Moving expense reimbursements are sourced to the employee’s new location.
Rental and Royalties
Sourcing of the use of tangible property is relatively straight-forward as the place of use is controlling. However, also included in this category are rents and royalties from the use of intangible property such as patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and other like property, which can create difficult scenarios to work through. For starters, intangible property has no physical location. In addition, intangible property can be used in many locations, with multiple licenses, across multiple jurisdictions. The Internal Revenue Code has attempted to simplify the approach. Under IRC Section 861, royalties from the same stream of licenses and sublicenses that are derived from the same intangible property could all be sourced to the United States.
Gains from the Sale of Property
Within this category of transactions, there are several types of property that carry different sets of rules. In its simplest form, the sourcing of the sale of property is tied to the place of sale. Certain transactions and deals are easy to figure out when all of the elements to a contract occur at the same location. However, some transactions can be more complicated. Sales of real property create the easiest situations, while the sale of personal property, intangible property and inventory present considerable challenges.
Sale of Real Property
IRC Section 861(a)(5) sources to the United States, “gains, profits, and income from the disposition of a United States real property interest.” U.S. real property interests include directly-owned real property and ownership of stock of a domestic corporation that owns an interest in U.S. real property. Gains attributable to each of these situations produce U.S.-sourced income.
Sale of Personal Property
In its simplest form, the Internal Revenue Code sources gains from the sale of personal property by a citizen and resident alien to the United States. The sale of personal property by a nonresident alien is sourced outside the United States. For these purposes, the rules for determining resident and nonresident alien status are different than those previously discussed and do not include the substantial presence test for foreign individuals.
Under the sourcing and status rules, IRC Section 865(g) states that a resident is any U.S. citizen or resident alien with no tax home outside of the United States or any nonresident alien with a tax home inside of the United States. Since the rules are different, certain individuals can be treated as resident aliens for some sections of the tax code, but as nonresident aliens for other parts.
Again, there are exceptions to the general rule. Citizens and resident aliens who pay an income tax equal to less than 10% of the gain from the sale of personal property to a foreign country can never be treated as nonresident aliens. Additional exceptions apply to the sale of depreciable property, intangible property and goodwill. For depreciable property, past depreciation is recovered with the same source of income it was used to offset. In determining the U.S.-sourced gain from the recovered depreciation, it bears the same proportion to the total gain as U.S. depreciation to total depreciation.
The rules surrounding the sale of intangible property contain their own caveats and exceptions. The main qualifier in this area is in the terms of the pricing included in the final contract. For fixed sales, residency rules control. The sale of intangible property by U.S. residents generally results in U.S.-sourced gain. The reverse occurs with foreign persons. For contingent sales, royalty rules control, meaning the income is sourced to the place of use of the intangible property.
Additionally, where the sale of intangible property contains returns of capital, the rules differ based upon the taxpayer. For a U.S. resident, the installment sale provisions would apply, and gain would be recognized accordingly. Conversely, payments to foreign persons are allocated first to return of capital. After that is exhausted, then gain may be recognized.
Regarding the sale of inventory, IRC Section 861(a)(6) looks to the place of sale in assigning the source. The problem in international transactions, as in all transactions, is that a number of steps are involved to complete a deal. For starters, some point of inquiry and negotiation needs to take place to arrive at the terms, but the terms of the final contract may be determined at another place. The final goods and title may also be set at a different location. Fortunately, the United States has determined and codified that the source of the sale is at the same time and location as the passage of title unless the rules were manipulated as a tax-avoidance scheme. Title passes at the point of delivery by default.
However, as with any contract, terms can be negotiated to reflect the will of the parties or to depart from standard procedures. Because of the ability to control the terms of a contract, taxpayers are presented with an opportunity to determine the sourcing of the sale of inventory. This is very important for all interested parties.
For foreign persons, crafting the title to pass outside of the United States will allow the income associated with the deal to escape U.S. taxation. For U.S. persons, shifting the passage of title to a foreign jurisdiction is also very important. In any scenario, the income will be taxable in the United States. However, for purposes of the foreign tax credit, it is advantageous for U.S. residents to push as much income as possible to the foreign-sourced category to take advantage of the foreign tax credit and its related limitation computation.
