Supercharged FTCs.

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

The foreign tax credit (FTC) reduces double taxation when income is subject to tax in more than one jurisdiction. There are two types of FTC, the "direct" and "indirect" credit; see Secs. 901 and 902, respectively. Under Sec. 901, U.S. taxpayers can claim a direct credit for taxes they have paid or that have been paid on their behalf. For a U.S. corporation, the types of income that can generate the direct credit include income (1) from conducting business in a foreign jurisdiction (whether directly, or through a partnership or disregarded entity) and (2) subject to foreign withholding taxes.

Under Sec. 902, an redirect credit can be claimed by a U.S. corporation that receives a dividend from a foreign corporation. For the redirect credit, the U.S. corporation can take a credit for foreign taxes paid by the foreign corporation; a formula determines the amount of foreign subsidiary income tax attributable to the dividend.

The indirect FTC permits several FTC maximization strategies. One revolves claiming a direct credit for the foreign subsidiary's income taxes, without receiving any dividends. Under this strategy, the U.S. taxpayer converts what would otherwise be an indirect credit into a direct credit by holding foreign subsidiary corporations through a wholly owned foreign company that the taxpayer elects to treat as disregarded for Federal tax purposes. This is accomplished by making a "check the box" election, under Regs. Sec. 301. 7701-3.

However, this strategy has been attacked by the IRS; see Guardian Industries Corp., Fed. Cl., Dkt. No. 02-1936T. Taxpayers claiming an FTC with little or no repatriation of income to the U.S. should be aware of both this litigation and the IRS's stated position on FTC strategies.

Notice 98-5

Notice 98-5 was the first guidance setting forth the IRS's view on FTC claims it deemed abusive. It announced the IRS's intent to issue regulations applying an economic-profit test to transactions designed to generate FTCs to offset U.S. tax on unrelated foreign-source income. The Service anticipated issuing regulations that would apply this test to disallow FTCs when the economic profit is insubstantial in relation to the FTC generated. Notice 985 also addressed certain transactions involving taxpayers claiming FTCs for income generated by property held for a very short time. Legislation addressed the short-holding-period transactions identified in Notice 98-5; see Sec. 901(k) and (1). Notice 2004-19, discussed...