Pooling of the Foreign Tax Credit
In the ongoing war over reforming the current United States tax system, one area of controversy is the taxation of business income earned from abroad. Of the many proposed changes by the Obama administration to the international provisions, of note is a change to the foreign tax credit (“FTC”) regime to determine FTC on a pooling basis instead of a stand-alone basis as is the practice today. If passed, this change could increase the tax burden for US based companies with overseas operations and tremendously impact the United States ability to attract multinational businesses.
Present Law on FTC
The US has a worldwide tax system. Domestic corporations are taxed on ALL of their income regardless of whether it is derived from US or foreign sources. In order to provide some relief from double taxation, a FTC is applied to foreign based earnings. The law allows the FTC to offset a portion of the US tax that is owed on income that has already been taxed in foreign jurisdictions. However, the FTC brings with it several restrictions. The FTC limitation is generally determined as the US tax liability a corporation would have paid on foreign taxable income.
US based corporations pay federal income tax when the earnings of their foreign subsidiaries are repatriated to the US. Foreign taxes paid by a foreign subsidiary, which repatriates funds to the US, are also deemed to have been paid by the US corporation. The deemed paid tax pool is calculated using amounts solely from the foreign subsidiaries that made actual or deemed distributions in the current year. As a result, each separate foreign subsidiary is looked at on a stand-alone basis.
The taxes deemed paid by the domestic taxpayer are limited to the ratio of the dividends paid to the actual distributing foreign corporation’s earnings and profits (“E&P”). The example below demonstrates the deemed paid tax pool of the foreign subsidiary that remits earnings to the US.
A foreign subsidiary remits a $100 dividend to its US parent out of its E&P of $300 on which total taxes of $150 have been paid to the foreign jurisdiction. The US parent may be able to take up to a $50 FTC ( =100/300 X $150)based on the $150 of taxes paid if it has additional foreign source income.
The current foreign tax credit allows the practice of “cross-crediting.” This term refers to using the foreign taxes paid in countries with higher tax rates to offset the same category of income of those in lower-taxed jurisdictions. The credit available from the highly taxed jurisdiction could offset a portion of the US tax on foreign income with a low tax rate. This type of tax planning is possible because of the separate calculation of the deemed paid tax pool limitation on each distributing company’s foreign taxes.
In the above example, the $100 dividend would result in a $35 US tax (assuming an US effective tax rate of 35%), resulting in a $15 excess FTC that would be available to offset the US tax on other foreign income of the US parent.
The proposed law would effectively treat all of a US corporation’s foreign subsidiaries on a consolidated basis instead of treating each foreign subsidiary as a separate company. This would severely limit the ability of companies to use the cross-crediting methodology by changing the calculation of the “deemed paid” limitation. This change would limit a US corporation’s foreign tax credits to the weighted average rate of total foreign taxes on the combined E&P of all foreign subsidiaries and thereby eliminate the ability to selectively access E&P of high taxed foreign corporations.
The amount deemed paid through ownership in foreign corporations would be calculated by applying the taxpayer’s pro-rata share of total foreign taxes paid by all companies to the ratio that the distribution bears to the total E&P of all foreign companies.
A US parent corporation with two foreign subsidiaries – FC1 has E&P of $300 on which total taxes of $150 have been paid to the foreign jurisdiction. FC2 also has E&P of $300 but only $50 of total taxes have been paid. FC1 remits $100 to the US parent. Instead of the $50 credit that was potentially available under current law, the two FCs must be combined even though FC2 didn’t distribute any earnings. By using the combined E&P pool of $600 and tax pool of $200, the US parent may be able to take only a $33 FTC (= 200/600 X $100).
The amount of taxes deemed paid by a certain distributing entity would differ from the amounts actually paid by that entity. This disparity is a result of pooling of a highly-taxed entity’s taxes and E&P with entities whose ratio of tax to E&P is not as high, thus averaging the ratio of all companies. This pooling would result in a deemed paid tax that is higher than actual tax paid for those entities that are subject to low tax rates, and higher taxed entities would report a deemed paid tax less than that actually paid.
Once again, the $100 dividend in Example 2A would result in a $35 US tax (assuming a US effective tax rate of 35%) to the US parent. Under the proposed FTC pooling rules, the available tax credit would be only $33. This would result in an additional US tax payment of $2 by the US parent corporation, despite the fact that the actual dividend paid had a much higher tax burden ($50), associated with it.
There are many consequences if this new proposal is passed. Clearly, multinational companies would have to develop new repatriation strategies as this proposal has no consideration for matching the source of the earnings to the foreign subsidiary which paid the foreign taxes . Instead, a blended foreign tax rate will drive up the effective tax rate by further limiting the foreign tax credit available. Additionally, this tax law change would potentially require changes to the tax provision, tax compliance software, and the associated processes. Ultimately, the largest consequence could be a significant increase in the actual tax burden, as well as the tax planning and compliance costs, for US based companies with overseas operations.
True Partners Consulting can help every multinational corporation by reviewing its current structure to limit the increased tax burden. This includes advising on legal entity structure, acquisition and dissolution plans, and the timing of repatriating distributions. In addition, True Partners Consulting has expertise in the latest tax and provision software to help keep your tax team ahead of the curve. True Partners Consulting can help your business identify trouble spots before they become full blown problems by assisting with adjustments to the current tax compliance or provision process and any increased compliance burden caused by this new proposal. For more information on what True Partners Consulting can do for your business, please contact the author at:
Or, contact any other member of our International Tax team:
John V. Aksak
Northeast Regional Managing Director
Robert M. Gordon
Northwest Regional Managing Director
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