Foreign Tax Credit: High Tax Kick-Out -
There can be considerable confusion amongst taxpayers who face foreign taxes as to what is creditable and how to allocate, calculate, and carry forward/carry back. There can still be surprises for those who feel they have a good grasp on the basics. One of the areas that can take a taxpayer by surprise is handling foreign tax credit for high taxed income.
Passive Foreign Income & Taxes
It might seem that a foreign source passive income item (including interest, dividends, royalties, and rents) would be in the passive category, and that would be it. However, there is the possibility that Country A would tax some passive income at a low rate and Country B would tax passive income at a high rate. Those taxes would lead to an average rate allowing the tax on the income from country B to be utilized for the income from Country A if nothing else were considered.
To limit the utilization of excess foreign tax credit created by high-taxed foreign passive income and still collect US tax on low-taxed passive income, the Internal Revenue Code provides an exception commonly referred to as the high-tax kick out (HTKO). If foreign passive income is taxed at a higher rate by the foreign country than the maximum US rate applicable, there is a requirement to “kick-out” the income from the passive category. High-taxed passive income is recategorized into general, foreign branch, Sec. 951, or income in a specified separate category based on the rules for those categories of income based on proposed regulations.
Groupings of Foreign Income & Taxes
Within the passive foreign income category is the necessity to break the category down into further sub-categories. Sub-categorization occurs by following the three grouping rules. Unless one of the additional grouping rules applies, the first grouping rule (general grouping rule) applies. The general grouping rule breaks the category down by withholding tax rates. The second and third grouping rules apply to income including:
- Dividends and inclusions from controlled foreign corporations, dividends from noncontrolled section 902 corporations, and income of foreign QBUs
- Certain rents and royalties, partnership income, and currency gain/loss
The general rule groups passive income into four passive income groups upon which the rate test is applied separately. Groupings are as follows:
- Subject to a withholding tax of 15% or greater
- Subject to a withholding tax greater than 0% and less than 15%
- Subject to no withholding tax or other foreign tax
- Subject to no withholding tax, but is subject to foreign tax other than withholding
Steps to Adress High Tax Kick-Out (in General)
- Determine foreign income
- Allocate foreign income initially into the separate categories based on the income type
- Gather associated expenses, losses, and other deductions.
- Break the foreign passive income category into sub-categories of passive income under the new grouping rules
- Consider each foreign passive income sub-category with associated expenses, losses, and other deductions against the associated foreign tax. Compare the foreign tax rate calculated against the maximum US tax rate applicable.
- If the foreign rate exceeds the US rate, the sub-category is highly taxed and must be considered related to other separate categories other than passive.
Example of High Tax Kick-Out
Logan Berry received foreign dividend income of $500 with associated deductions of $300. Due to his residency status, he is taxed $100 in the foreign country on that foreign dividend income. After allocating the associated deduction, the potentially double-taxed income is $200. The tax of $100 on the $200 exceeds the max US rate. Therefore, the income, deduction, and tax are kicked out to the general category.
If Logan had previous passive foreign income with not enough tax, this would prevent Logan from being able to carryback the excess passive foreign tax from the current year to offset the prior-year foreign passive income.
Taxpayers should pay close attention to how the foreign income is taxed and the various associated expenses/losses/deductions. Foreign tax credits sound easy – income taxed in two places means you get a credit for the double taxation, but the nuances to how it is calculated are crucial to consider. The need to pay close attention to foreign tax credits is especially true post- Tax Cuts and Jobs Act, which has added new categories for foreign taxes to fall under and added new rules about how the tax credit is calculated.
The International Tax Team at Ryan & Wetmore is well-experienced with foreign tax credits. For questions or concerns regarding your international requirements, accounts, entities, income, and assets, click here to email our foreign tax team. Please be aware that tax issues are complicated and may vary based on the details of your situation. For this reason, an initial phone call is generally required to obtain the facts and address the questions.
By Bethany Banks, CPA
About Traci Getz
Partner & CPA
Traci Getz is a partner with Ryan & Wetmore, P.C. Traci has over fifteen years of experience providing accounting, tax, and consulting services to small and medium-sized business owners. She works with clients to understand their accounting and tax issues while specializing in international tax, healthcare, and construction.