wwwPaylesstaxcom
Toll Free (877)CPA-Help or (877)272-4357

Don Fitch CPA's professional services include Guaranteed results with the IRS, tax returns for ALL 50 STATES,  Financial and IRS Audits, Financial Reviews, Compilations, IRS Discovery's, Natural Disaster Relief, Lender Letters, and CPA Employment Verification

Foreign Earned Income Exclusion
OVERVIEW

Taxpayers (both individual and other) can make an election to claim a
credit against their United States income tax liability for certain
eligible taxes imposed by foreign countries and possessions of the United
States. Code Sections 27, 901. Eligible taxes include "income, war
profits, and excess profits taxes" paid or accrued during the taxable
year. Code Section 901(b). For these purposes, a foreign country means
any foreign state and any political subdivision of a foreign state.
Possessions of the United States include Puerto Rico, the Virgin Islands,
Guam, the Northern Mariana Islands, and American Samoa.

OBSERVATION: The foreign tax credit is intended to relieve United
States taxpayers of double taxation. The credit offsets -- on a
dollar for dollar basis -- and subject to various limitations the
U.S. tax on foreign source income that would otherwise be subject to
taxation both by the United States and by the foreign country in
which the income is generated.  In general, if the foreign tax
rate is equal to or higher than the United States tax rate, there
will be no U.S. tax on the foreign income. If the foreign tax rate is
less than the United States rate, the U.S. tax on the foreign income
will be limited to the difference between the rates. Since the
foreign tax credit applies only with respect to foreign source
income, it is not available for taxes paid to a foreign country
attributable to United States source income.

The foreign tax credit is also available for taxes paid in lieu of a tax
on income, war profits, or excess profits taxes otherwise generally
imposed by a foreign country or possession of the United States. Code
Section 903. In addition, for domestic corporations that own 10 percent or
more of a foreign corporation, an indirect credit -- the deemed paid
credit -- is available. Code Section 902(a). In the case of a controlled
foreign corporation (CFC), Code Section 960 serves a similar purpose. The
rules for the deemed paid credit in the case of multiple tiers of
corporations can become especially complex. See Code Section 902(b).
Subject to some exceptions, no foreign tax credit is allowed for any
taxes paid to a foreign country that the United States does not
recognize; that the United States has severed diplomatic relations with
or with which it does not conduct such relations; or that provides
support for international terrorism, unless this restriction is waived by
the President. Code Section 901(j). A similar provision denies the credit
(or some percentage of the credit) if the taxpayer participates in or
cooperates with an international boycott within the meaning of Code
Section 999. Code Section 908(a). There are a number of additional
restrictions, exceptions, and special rules applicable to the credit that
are discussed in this chapter.

The foreign tax credit can offset only a taxpayer's U.S. income tax
liability. No credit is allowed against any U.S. tax that is not treated
as an income tax under Code Section 26(b), including the alternative
minimum tax, although a separate alternative minimum tax foreign tax
credit is allowed. For 2000 through 2003, the tax that can be offset
is equal to the full amount of the U.S. regular income tax liability,
unreduced by other tax credits. Code Section 904(h). Starting in 2004, in
the case of individuals, the tax against which the foreign tax credit is
taken generally is the tax reduced by the sum of the non-refundable
personal credits described in Section 52.1, other than the child tax
credit discussed in Ch. 57, the adoption credit discussed in Section
58.2, and the credit for qualified savings contributions, discussed in
Ch. 115.

For any qualifying or eligible foreign tax, the credit is subject to
precise and detailed limitations set forth in Code Section 904. See
Section 55.6 The limitations separate income into a variety of
categories. Code Section 904(d). Stated broadly, the section attempts to
segregate types of income, such as passive income and other types of
investment income, that could be subject to manipulation or abuse. The
separate limitation categories are generally referred to as separate
"baskets" of income. Reg. Section 1.904-4(a).

Taxpayers have a choice each taxable year with respect to foreign taxes
that qualify for the foreign tax credit. Instead of electing the foreign
tax credit, a taxpayer can claim a deduction for these taxes. Code
Section 164(a)(3).  A taxpayer can choose each year whether to take
the credit or a deduction, and he can change his choice, by amending his
return, for any given year.

PRACTICE TIP: Taxpayers are denied any double benefits from combining
the foreign tax credit (or deduction) with the foreign earned income
exclusion. A taxpayer cannot take a foreign tax credit or a deduction
on any taxes attributable to income that has been excluded under the
foreign earned income exclusion or the foreign housing amount
exclusion. Code Section 911(d)(6). Income subject
to foreign taxation in excess of the applicable amounts in Code
Section 911, however, is eligible for a deduction or credit. The
foreign earned income exclusion (and housing allowance) are discussed
in Ch. 161.

The taxpayer elects annually to claim either the foreign tax credit for
all qualifying foreign taxes or to deduct the foreign taxes paid. The
election to take a credit instead of a deduction for qualified foreign
taxes may be made or changed at any time during the period in which a
claim for credit or refund of United States tax can be filed -- that is,
within 10 years from the date a return was filed for the year in which the
taxes were actually paid or accrued, unless the period is extended by
agreement. <6> A taxpayer may switch from claiming a deduction to a credit
within the 10-year period regardless of whether the foreign tax credit is
claimed under the Code or a treaty. FSA 200032037.

If the credit is chosen, the taxpayer may not take any part of that year's
foreign taxes as a deduction. Code Section 275(a)(4). The reverse is true
as well. If the taxpayer elects to deduct foreign taxes, he must deduct
all of them. Partial credits and partial deductions are not permitted.
Reg. Section 1.901-1(c). However, there are several exceptions to this
all or nothing rule.

Perhaps surprisingly, when the foreign tax credit is taken, those foreign
taxes not allowed as a credit because of the boycott provisions or denied
the credit with respect to certain rogue countries may be deducted. Code
Section 908(b) and Code Section 901(j)(3). Another exception allows a
taxpayer who has paid withholding tax on dividends from a foreign
corporation, but who did not hold the stock for the requisite period of
time under Code Section 901(k)(1), to take the deduction even through the
credit is denied. Code Section 901(k)(7).

A somewhat different exception exists for non-creditable taxes, such as
foreign real property taxes and certain tariffs and levies. These may be
deducted in any case, without regard to whether the foreign tax credit is
claimed for other eligible taxes. Code Section 164(a)(1) and Code Section
275(a)(4).

PRACTICE TIP: For most taxpayers, it is usually more advantageous to
take the foreign tax credit than to take a deduction for foreign
taxes paid. A deduction from income serves only to reduce taxable
income while the credit reduces actual tax liability. On a dollar
basis, a tax deduction is only worth the value of the taxpayer's
maximum tax bracket for that income. The credit, on the other hand,
reduces the taxpayer's actual U.S. tax liability by the dollar amount
of the qualifying foreign taxes paid.

EXAMPLE 1: A taxpayer is in the 27.5 percent U.S. income tax bracket
for 2001. His deduction of $1,000 in foreign taxes paid is worth, at
most, $280 (less in later years, when the brackets will be lower),
the value of his maximum income tax bracket. If he elects the foreign
tax credit, the $1,000 is worth $1,000. If qualifying, the taxpayer
deducts (credits) his overall U.S. tax liability by the full amount
of $1,000 for the foreign taxes he paid.

EXAMPLE 2: A U.S. taxpayer receives a $1,000 dividend from a foreign
corporation in 2001. He pays tax to the foreign country, at a 30
percent rate, a tax of $300. His U.S. marginal tax rate is 30.5
percent. If he deducts the $300 foreign tax (leaving him with a
taxable income of $700) he pays a $214 United States tax ($700 x 30.5
percent = $214). His total tax liability on $1,000 of taxable income
therefore, is $514 ($300 plus $214 = $514). If, however, the taxpayer
elects to credit the $300 foreign tax against his $305 United States
tax ($1,000 x 30.5 percent = $305) otherwise due, his United States
tax is $5 ($305 minus $300 = $5). His total tax liability is $305,
which is $209 less than if he had taken the deduction.

However, there are circumstances in which the deduction is more
beneficial than the credit. For example, although excess credit
carryovers are allowed, if a taxpayer has insufficient foreign source
income to claim the credit, the carryovers have time limits and might
expire before they can be absorbed. Also, if the taxpayer will suffer
an overall net operating loss (NOL), he would have no tax liability
against which to use the credit. A deduction in this case would
increase the NOL. Thus, in effect, the taxpayer would extend the time
period for a carryforward from the five-year period allowed the
credit to the twenty-year period allowed the NOL. Code Section
172(b)(1)(A)(ii). For most taxpayers however,
the credit will usually be preferable.

CAUTION: A taxpayer claiming the foreign tax credit may be liable for
the alternative minimum tax (AMT) under Code Section 55(a). A set of
special rules applies for the "alternative minimum
foreign tax credit." See Code Section 59. The AMT
generally is discussed in Ch. 60. The AMT foreign tax
credit is specifically covered in Section 60.13

In certain circumstances, the credit may be denied altogether. The IRS has
published its concerns that certain taxpayers (primarily multinational
corporations) may enter into arrangements that would lead to abuse of the
foreign tax credit. In the IRS's view, abusive arrangements generally are
those that yield little or no economic profit relative to the expected
U.S. tax benefits derived from the availability of the foreign tax credit;
they thus provide a shelter for low-taxed foreign-source income from a
residual U.S. tax. Such arrangements are more fully described in Notice
98-5, 1998-1 C.B. 334.

The IRS has argued, and two lower courts have agreed, that certain
transactions involving American Depository Receipts (ADRs) have no
economic substance or a business purpose and that foreign tax credits
arising from the transactions will not be allowed. Two Circuit Courts of
Appeals, however, have emphatically rejected the argument and reversed the
lower decisions, holding that as a matter of law the ADR transactions
involved have economic substance and a business purpose. In Compaq
Computer Corporation v. Commissioner, No. 00-60648 (5th Cir. Dec. 28,
2001), rev'g 113 T.C. 363 (1999), the taxpayer purchased ADRs,
representing stock in the foreign corporation Royal Dutch Petroleum,
immediately before the record date for payment of a dividend. Holders of
the ADRs on the record date were entitled to the dividend, whereas
holders after the record date were not. Compaq sold the ADRs immediately
after the record date at a loss, reflecting the fact that the purchaser
would not be receiving the dividend. The dividend was subsequently paid
to Compaq, and Royal Dutch withheld a portion of the payment to pay the
Netherlands income tax. Compaq claimed a short-term capital loss and a
foreign tax credit for the tax paid to the Netherlands.

The Tax Court found that without the tax benefit, Compaq would have
experienced an overall loss on the transaction and that the transaction
lacked economic substance and had no business purpose. The court stated
that there was no reasonable possibility of a profit from the transaction
without the anticipated federal income tax consequences and that the only
reason for the purchase and sale of the ADRs was to obtain the income tax
benefit -- in effect, the court stated, the purpose of the transaction was
the acquisition of a foreign tax credit rather than the acquisition of
ownership in Royal Dutch. Because there was no economic substance or
business purpose, the foreign tax credit was disallowed.

The Fifth Circuit, however, reversed the decision and held that as a
matter of law, the transaction had both economic substance and a business
purpose. The court stated further that the Tax Court had erred as a matter
of law by disregarding the gross amount of the dividend that Compaq
received, prior to paying the foreign tax, and thus ignoring the company's
pre-tax profit on the ADR transaction. It pointedly and specifically
called into question the intention of the IRS, announced in Notice 98-
5, 1998-1 C.B. 334, to determine reasonably expected economic profit by
taking into account foreign tax consequences but not U.S. tax
consequences of transactions, and by treating foreign taxes as an expense
without regard to whether they are deductible in determining taxable
income. If the effects of tax law, domestic or foreign, are to be
accounted for when they subtract from a transaction's net cash flow, the
court reasoned, tax law effects should be counted when they add to cash
flow as well. To count them only when they subtract from cash flow is to
stack the deck against finding the transaction profitable. The IRS has
offered no reason to endorse its approach, the court stated, and the fact
that the government would get more money from taxpayers does not suffice.

Similarly, in IES Industries, Inc. v. United States, 253 F.3d 350 (8th
Cir. 2001), rev'g No. C97-206 (N.D. Iowa Sept. 22, 1999), the Eighth
Circuit reversed a district court and held that the taxpayer's
arrangement in which it bought ADRs with the dividend rights attached and
then promptly sold the ADRs at a loss while retaining the right to the
dividend was not a sham transaction. As a result, the taxpayer was
entitled to capital losses and foreign tax credits arising out of the
arrangement.

The court in IES Industries rejected the IRS's argument that there was no
economic benefit to the transaction. According to the court, the economic
benefit to IES was the amount of the gross dividend, before the foreign
taxes were paid. IES was the legal owner of the ADRs on the record date,
the court stated, and as such, it was legally entitled to retain the
benefits of ownership, that is, the dividends due on the record date.
Because the entire amount of the ADR dividends was income to IES, the
court concluded that the ADR transactions resulted in a profit, an
economic benefit to IES.

The holding period rules of Code Section 901(k), added by the Taxpayer
Relief Act of 1997, Pub. L. 105-34, make transactions such as those
employed by Compaq more difficult. Code Section 901(k) requires the
recipient of a dividend to hold the stock for at least 16 days during a 30-
day period, beginning 15 days before the date the stock goes ex dividend
in order to be eligible for the foreign tax credit. Code Section
901(k)(1). A 46-day/90-day rule applies to some preferred stock dividends.
Code Section 901(k)(3). Taxpayers denied a foreign tax credit because of
these rules, however, may still be allowed a deduction. Code Section
901(k)(7).

TO CONTACT
wwwPaylesstaxcom

Call Toll Free for our assistance/help at: (877)CPA-Help or (877)272-4357.

Email your request for our assistance/help to: DonFitchCPA@paylesstax.com.

Website Contact Form  http://www.paylesstax.com/dfacontact.html

Video Conference with a CPA!

Fax your request for our assistance/help to: (760)836-0968 or (760)406-5001.

Chat Live with a CPA

Professional
 Services

www.Paylesstax.com's Favorite Accounting Links
 
www.Paylesstax.com's Favorite Tax Links
 
www.Paylesstax.com's Favorite IRS Links
 
www.Paylesstax.com's Favorite State Tax Links
 
www.Paylesstax.com's Favorite Tax Publisher & Research Links
 
www.Paylesstax.com's Favorite Computer Links
 
www.Paylesstax.com's Favorite Continuing Professional Education Links
 
www.Paylesstax.com's Favorite Library Links
 
www.Paylesstax.com's Favorite Internet Links
 
www.Paylesstax.com's Favorite Internet Purchasing Links
 
www.Paylesstax.com's Favorite Stock Market Links
 
www.Paylesstax.com's Favorite Travel Links

Professional Fees