Q: How does the tax treaty between the U.K. and the U.S. work with regard to a U.K. subsidiary wholly owned by a U.S. entity? Does the U.S. entity get to use the U.K. taxes paid as a credit on its tax return?
Yes, in general, U.K. taxes can be claimed as a credit on the U.S. parent’s tax return. The purpose of this “foreign tax credit” is to eliminate double taxation of foreign source income. In effect, the foreign tax is treated as a down payment on the domestic taxpayer’s U.S. tax liability with respect to that income.
It is important to note that a domestic corporation that owns at least 10 percent of the voting stock of a foreign corporation is entitled, under Sec. 902, to claim a credit for the foreign income taxes paid by the foreign corporation, on its accumulated profits, in the year in which the domestic corporation receives a dividend from the foreign corporation. This so-called “derivative” credit roughly parallels the dividends received deduction (of Sec. 243) for dividends paid by U.S. corporations.
This Sec. 902 credit is generally determined by multiplying the cumulative foreign income taxes of the foreign corporation by a fraction: The numerator of the fraction is the dividends received for the year and its denominator is the foreign sub’s accumulated profits. Accumulated profits are, in general, equated with earnings and profits of the foreign corporation and are determined in accordance with domestic law principles under Sec. 312. Note that under the “gross up” approach, that’s employed for this purpose, the domestic corporation first computes its Sec. 902 credit and then includes this credit amount in its gross income as a dividend under Sec. 78.
Foreign taxes are not necessarily allowed as a credit in full against domestic tax liabilities; Sec. 904, instead, limits the credit to the amount of U.S. taxes “attributable to” the taxpayer’s foreign source taxable income. The basic limitation is expressed as a fraction: U.S. taxes are multiplied by foreign-source taxable income divided by total taxable income. The effect of this limitation is that foreign- source income is taxed at the higher of the U.S. tax rate or the foreign effective rate. To eliminate the practice of “cross-crediting”, or “averaging down” the effective foreign tax rate on foreign-source income (and thus avoiding the general limitation) by generating additional foreign source income taxable at a low foreign tax rate, the law requires a separate limitation computation for the taxpayer’s various categories of “separate basket” income. At present, for purposes of the foreign tax credit rules, there are eight specified categories of foreign source income that you can find listed in Sec. 904 (d).
Finally, it’s important to note that credits can arise in cases where the domestic corporation receives “deemed” dividends from its foreign subsidiary, a corporation that’s classified, for U.S. tax purposes, as a “Controlled Foreign Corporation”. Such deemed dividends will arise in cases where the foreign subsidiary generates so- called “Subpart F” income or makes “investments in U.S. property.”
Robert Willens, Tax and Accounting Analyst
Lehman Brothers Holdings Inc.
Crow Chizek & Co. LLP’s Terry B. Arch adds that in a proposal announced on Wednesday, a new U.S.-U.K. tax treaty will be up for approval by the U.S. Senate and the U.K. Parliament. The new treaty will call for fewer taxes imposed by the U.K.
The treatment of a foreign-tax credit taken by the U.S. parent for U.K. taxes paid will not change with the new treaty.
However, when the U.K. profit is repatriated as a dividend, the current treaty imposes a five-percent withholding tax, which was also available as a foreign tax credit. The new treaty eliminates this five- percent withholding tax.
Terry B. Arch, International Tax Partner
Crowe Chizek & Co. LLP
See previous “Ask the Experts” columns:
Paperwork for Customers in Tax-Free States
Licensing Fees in Japan
Buy-out Legal Fees and Treasury Stock
A Merger Accounting Scenario
A FAS 133 Example
Recognizing Upfront Fees
Proving Tax-exempt Status
The ABCs of OECD
Credentials for Credit
Big Five Audits and Venture Funding
GAAP for Private Firms
Insurance for E- business Infrastructure
401(k) Brokerage Links
Navigating the Rough Waters of Sales Tax
Ask the Experts is a weekly column that aims to help finance executives like you find answers to difficult questions.
Submit your questions by E-mailing them to [email protected]. Unfortunately, we cannot answer all questions individually.
While we will enlist professionals to try to answer your questions, Ask the Experts is meant only to create a dialogue on the topics. Consult legal or financial professionals before acting on any of the advice given by our expert panel.