FTC baskets reduced to two.

• Author: Zink, Bill
• Position: Foreign tax credits

Income earned by U.S. companies doing business abroad is susceptible to double taxation--once 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...