How reduced rates for capital gains and qualified dividends affect the FTC.

• Author: Vermeer, Thomas E.
• Position: Foreign tax credit

EXECUTIVE SUMMARY

* With reduced rates on capital gains and dividends, it is more likely that a taxpayer's foreign taxes win exceed the FTC limit.

* Taxpayers with capital gains and/or dividends taxed at a reduced rate are required to adjust the maximum FTC calculation.

* Tax advisers should check whether their software is calculating the maximum FTC credit for both regular tax and AMT purposes.

Reduced rates for capital gains and qualified dividends affect the maximum allowable foreign tax credit (FTC) for many taxpayers. This article explains in detail how such reduced rates influence the FTC computation.

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This article is an overview of the effect of reduced tax rates on capital gains and/or qualified dividends on the maximum allowable foreign tax credit (FTC) for individuals. Specifically, it addresses the (1) mechanics of the adjustment made to the maximum allowable FTC; (2) reasoning behind the percentages used for the adjustment; (3) adjustment's effect on the alternative minimum tax (AMT); (4) changes in FTC carryback and carryforward rules; (5) advantages and disadvantages of claiming a deduction versus a credit for foreign taxes paid; (6) de minimis exemption to the FTC limitation; and (7) status of software programs and the calculation of the maximum allowable FTC.

Basic FTC Computation

The basic premise behind the FTC is to provide relief from double taxation of income from foreign sources. Under Sec. 904(a), the credit is limited to the taxes that would have been paid to the U.S. on foreign-source income. The maximum allowable credit is the proportion of an individual taxpayer's foreign-source taxable income over the taxpayer's total U.S. taxable income before deducting personal and dependency exemptions, multiplied by the taxpayer's U.S. income tax before any tax credits. In other words, it is the taxpayer's average Federal tax rate multiplied by the taxpayer's foreign-source taxable income. For example, if a taxpayer has $40,000 of foreign-source income, $150,000 of U.S. taxable income before exemptions and $30,000 of U.S. income tax before any tax credits, the maximum allowable credit is $8,000 (($40,000/$150,000) x $30,000). The $150,000 of U.S. taxable income is worldwide income and includes the $40,000 of foreign-source income.

The calculation of the maximum allowable FTC is rather simple, until the reduced income tax rates on capital gains and/or qualified dividends are considered. Although a lower tax rate on capital gains has existed for many years, the reduction of the individual income tax rates on qualified dividends to 15% (5% if the taxpayer is in the 10% or 15% income tax bracket) by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) has substantially increased the probability that tax practitioners will be confronted with this calculation. (1)

Adjustment to Maximum Allowable FTC

If taxpayers' capital gains and/or qualified dividends are taxed at a reduced rate, they are required to adjust the numerator (foreign-source taxable income) and/or denominator (U.S. taxable income before exemptions) for purposes of the maximum allowable credit calculation, under Sec. 904(b) (2)(B). They have to adjust only the denominator if their foreign-source income was not taxed at a reduced rate. They have to adjust both the numerator and the denominator if all or a portion of their foreign-source income was taxed at a reduced rate. Some type of adjustment is made regardless of the origin of the reduced tax rates for capital gains and/or qualified dividends. For example, a taxpayer with no foreign-source income that qualifies for reduced tax rates is still required to adjust the denominator if the taxpayer's domestic capital gains and/or qualified dividends were taxed at a lower rate.

Although the FTC adjustment calculation is fairly complex, the reason for the adjustment is to ensure that taxpayers do not receive an FTC greater than the Federal income taxes paid on the foreign-source income. Thus, if the foreign-source income is from capital gains and/or qualified dividends taxed at the reduced U.S. income tax rates, the adjustment ensures that the maximum allowable credit does not exceed the reduced income tax as a result of those rates. In contrast, if the foreign-source income is ordinary income taxed at regular income tax rates, the adjustment ensures the maximum allowable credit is based on the taxpayer's regular income tax rates, rather than the reduced tax rates on capital gains and/or qualified dividends.

Adjustment Calculation

Exhibit 1 on p. 416 illustrates the calculation and how an adjustment to the numerator and/or denominator ensures the taxpayer does not receive an FTC greater than the Federal income taxes paid on the foreign-source income. An adjustment calculation worksheet is provided by the IRS in the 2005 Instructions to Form 1116, Foreign Tax Credit; see p. 17 (worksheet for line...