Published in Tax Notes International, Tax Analysts, Vol. 111, No. 6, August 7, 2023.
The Creditability of Contemporaneously Paid Foreign Taxes
By Anthony Malik
INTRODUCTION
Taxpayers earning foreign source income can satisfy their foreign tax liabilities in one of several different ways depending on the character of the income earned, the taxpayer’s level of foreign activity, and local tax laws and practices, among other factors. A comprehensive understanding of a taxpayer’s foreign activities and the mechanisms by which such taxpayer satisfies his or her foreign tax liability is critical for United States (“U.S.”) tax practitioners because this allows them to ascertain the proper amount of foreign taxes paid for U.S. creditability purposes.[1] In practice, it is not uncommon for practitioners to view their clients’, particularly those on the cash basis method of accounting, foreign tax payments in a static manner. There is a tendency to simply translate into U.S. dollars taxpayers’ total amount of foreign taxes paid within their U.S. tax year via all mechanisms (e.g., withholding, estimated tax payments, prepayments, and payments remitted along with the filing of their foreign tax returns etc.) followed with the calculation of the foreign tax credit thereon. However, depending on any given cash basis taxpayer’s facts and circumstances, there could very well be differences between the amount of foreign taxes paid during his or her U.S. tax year and the amount of paid foreign taxes that may be claimed by the taxpayer as a credit during that same U.S. tax year.
As we shall see, possible divergence between the amount of foreign taxes paid and the amount of paid foreign taxes that are creditable can lead to timing differences. While this paper is written from the perspective of an individual claimant,[2] the rules discussed herein also apply almost equally to corporate claimants. To keep the topic manageable, the foreign taxes discussed herein should be construed as qualified (i.e., creditable) income taxes representing a U.S. taxpayer’s legal and actual liability contemporaneously remitted to a foreign country that is not sanctioned by the U.S. Secretary of the State.
In the ensuing sections of this paper, we will first examine the non-authoritative guidance on this issue as provided through material developed by the Internal Revenue Service (“IRS”) that is specifically directed toward the public for promoting, and assisting in, tax compliance—we will not review any relevant guidance that may be contained within material developed by the IRS for internal employee training and guidance (e.g., Audit Technique Guides, Practice Units, Internal Revenue Manual etc.) that the IRS is obligated to electronically publish pursuant to disclosure laws generally applicable to federal agencies.[3] Once we reach the limits of what one can reasonably and responsibly discern therein, we will then turn to the specificity of the relevant guidance contained within the law to round out our understanding of the subject matter.
REVIEW OF THE RELEVANT IRS MATERIAL
Material provided by the IRS is an appropriate starting point for our discussion because compliance-oriented tax practitioners are most likely to—in many cases, for very good reason—first turn toward instructions to tax forms and various handbooks in the resolution of queries germane to their clients’ reporting requirements. While the purpose of such material is undoubtedly to lead return preparers step-by-step to accurately report the necessary information required by the law, it is no secret that in many instances it fails to provide appreciable guidance. As we shall see, claiming a credit for paid foreign taxes pursuant to Internal Revenue Code (“IRC” or “Code”) Section 901(a) is one such instance.
Form Instructions
The instructions to Form 1116 are surprisingly scant in this area. They state, in relevant part, that “Generally, you can take a foreign tax credit in the tax year you paid… the foreign taxes.”[4] They further state that “Generally, you must enter in Part II[5] the amount of foreign taxes… that relate to the category of income checked above Part I.[6] Taxes are related to the income if the income is included in the foreign tax base on which the tax is imposed.”[7]
Remarkably, the instructions do not state anything beyond this regarding the determination of either the amount of foreign taxes paid for creditability purposes or the U.S. tax year within which such paid foreign taxes become creditable. As we shall see, particularly once we begin delving into the authoritative sources of the law, this is problematic because witting reliance on the form instructions alone largely misleads practitioners in both regards. It can be hoped that experienced practitioners would recognize that the insufficiency of the forgoing instructions conceal something practically consequential and that the process of questioning, the search for answers, is to continue.
Publication 514
Fortunately, however, Publication 514, Foreign Tax Credit for Individuals, at least partially addresses these issues. Publication 514 specifies that “If you use the cash method of accounting, you can claim the credit only in the year in which you pay the tax. You are using the cash method of accounting if you report income in the year you actually or constructively receive it, and deduct expenses in the year you pay them.”[8] “You can claim the credit for a qualified foreign tax in the tax year in which you pay it… “Tax year” refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed.”[9] This verbiage serves to implicitly convey guidance of greater consequence; taken together, it is at least rudimentarily instructive with respect to the determination of the U.S. tax year within which paid foreign taxes become creditable.
While not immediately obvious, it provides that taxpayers are not to apportion the paid amount of their foreign taxes between two separate U.S. tax years in the event of a foreign fiscal year that does not coincide with the Gregorian calendar-based U.S. tax year. To illustrate, consider the UK fiscal year that runs from April 6 of any given year to April 5 of the following year. Now, in the context of the UK fiscal year ending April 5, 2023, if a U.S. taxpayer accurately determines and pays the full amount of his or her final UK tax liability on April 6, 2023, the taxpayer ought not apportion the payment between two U.S. tax years over which the UK fiscal year falls (i.e., from April 6, 2022 to December 31, 2022 and January 1, 2023 to April 5, 2023). Rather, for purposes of potential U.S. creditability, such taxpayer would claim the entire amount of the paid UK taxes during his or her 2023 U.S. tax year.
Publication 514 is also instructive—though, again, not explicitly—in that paid foreign taxes do not relate back to the U.S. tax year in which the liability arose. This happens to be the case whether or not the foreign fiscal year coincides with the U.S. tax year. For the sake of simplicity, let us consider a U.S.-coincident foreign fiscal year. If a hypothetical U.S. taxpayer remits payment in satisfaction of his or her 2022 foreign tax liability on January 1, 2023, while the foreign income on which the tax is eventually imposed is taken completely into account during the 2022 U.S. tax year, the correct reading of Publication 514 is that the foreign taxes are taken into account in 2023.[10] Such temporary timing mismatches between cash basis taxpayers’ foreign source income and the remittance of taxes thereon are very common.
The chief problem with the relevant guidance in Publication 514 is that it too zealously pegs the year of credit to the year of payment. Further compounding the problem is the fact that the line verbiage of Form 1116, Part II,[11] upon asking for the date of payment of the foreign taxes, when considered in the context of the relevant guidance contained in the instructions to Form 1116 and Publication 514, can easily mislead practitioners into unexceptionally reporting the amount of foreign taxes paid during the U.S. tax year for which the form is being prepared. It is not at all obvious that, counterintuitively enough, the correct date of payment to be listed on Form 1116 for a given year can pertain to a past (though not a future) U.S. tax year. A review of the IRS material, no matter how thorough, does not make it obvious that in some cases foreign taxes paid in a current U.S. tax year may not become creditable until a future U.S. tax year. Although the narrative coherence of the IRS material is assuring, making the relationship between the payment transaction and the timing thereof appear dyadic, it effectively precludes one from questioning whether there are instances wherein the two are separable.
It is not until we turn to legal guidance in this area that we begin realizing that the treatment prescribed by the IRS material is most generally applicable to taxpayers with relatively limited foreign activities. In other cases, the determination hinges largely on the specific facts and circumstances of the taxpayer and, to a lesser extent, on the practitioner’s discretion.
OVERVIEW OF THE RELEVANT LAW
In spite of the useful guidance provided by Publication 514, it falls short of explaining how the rules apply in specific instances of relatively common cross-border scenarios. In this section we shall turn to substantive guidance to gain a more complete understanding. We shall approach the subject matter by considering how the rules apply to taxpayers with differing levels of foreign activity earning various types of foreign source income.
Foreign Taxes on Portfolio Income
An overview of the law makes it clear that the odds of immediate creditability of contemporaneously remitted foreign taxes are inversely proportional to the taxpayer’s level of foreign activity. To wit, a credit is allowed for a reasonable approximation (or, for that matter, less than a reasonable approximation) of a taxpayer’s final foreign tax liability. This rule applies most aptly to taxpayers with minimal foreign activities. If the amount withheld is reasonably assuredly the amount of a taxpayer’s final foreign tax liability then a credit can be claimed for the amount of foreign taxes withheld during the U.S. tax year. This would be most true, for example, of a gross basis withholding tax applied against an isolated stream of portfolio income[12] of a U.S. taxpayer lacking a trade or business in the foreign country.
In this regard, Revenue Ruling (“Rev. Rul.”) 57-516[13] provides that “The credit provided in section 901 of the Code is not based on tax withheld by a foreign country or possession of the United States during the taxable year, since tax withheld is merely an advance collection of what may or may not be an actual tax liability.” After this elucidation Rev. Rul. 57-516 proceeds to allow a credit for foreign taxes withheld by a foreign corporation paying dividends to a U.S. taxpayer. The language of the ruling suggests that the dividends are the only foreign source income of the U.S. taxpayer.
It should be noted that the straightforward guidance handed by Rev. Rul. 57-516 inheres in the foreign source portfolio income of taxpayers with minimal foreign activity. Though the acknowledgement of this guidance may assure one with the feeling that one is in a space replete with meaning and that the law is not completely arbitrary or mysterious, one cannot overlook that the treatment articulated in Rev. Rul. 57-516 would not necessarily be applicable to all taxpayers earning foreign source portfolio income. For example, reliance on Rev. Rul. 57-516 would probably not be appropriate for a taxpayer with an active trade or business in a foreign country who was also earning foreign source portfolio income subject to withholding taxes at source. Such a taxpayer would, depending on his or her complete set of facts, likely be required to determine his or her final foreign tax liability following the close of the foreign fiscal year before he or she could claim a foreign tax credit. In such cases the withheld foreign taxes are akin to estimated tax payments which are uncreditable until such taxpayer’s final foreign tax liability is settled.[14]
Foreign Taxes on Trade or Business Income
On the other end of the spectrum, foreign taxes paid during the U.S. tax year either via withholding, estimated payments, or prepayments do not qualify for the foreign tax credit during the same U.S. tax year if the taxpayer is engaged in a trade or business in the source country. The apparent rationale for this treatment, as can be gleaned from the guidance, is that business profits are taxed on a net, instead of on a gross, basis determined under foreign legal principles.
Rev. Rul. 71-517[15] addressed the question of creditability when a U.S. partnership was engaged in a business in Peru. Under Peruvian law at the time, entities incorporated or registered outside of Peru that were engaging in mining operations in Peru where required to prepay an amount representing a percentage of the net value of the mining products exported. These prepayments would subsequently be applied against such entities’ ultimate Peruvian income tax liability once it was determined. It was held that the advanced payments were not taxes at the time of payment because they were more akin to deposits against a future tax liability than payment of taxes. However, the ruling specified that any portion of such prepayments, once applied against the properly determined and assessable amounts of Peruvian income taxes qualified as payments of creditable foreign income taxes.
Rev. Rul. 70-425[16] had previously also reached a similar conclusion in denying an immediate credit for foreign taxes withheld on income attributable to business profits. The ruling considered a taxpayer that earned both business and non-business income from Italian sources. With respect to the taxpayer’s non-business income, the ruling didn’t address whether a reasonable approximation of the withheld Italian taxes would be immediately creditable; instead, it simply provided that the ultimate liability against which such withheld taxes would be applied would be creditable. As for the Italian taxes withheld on the taxpayer’s business income, the ruling was clear that such withheld taxes would not be separately allowable as a credit until the taxpayer’s final Italian tax liability was settled.[17] As such, the settlement is essentially the event that transmutes uncreditable advance deposits against future foreign tax liabilities into actual payments of foreign tax liabilities, creditable to the extent of the settled amounts. The reasonability of the approximated final foreign tax liability is apparently immaterial with respect to income derived in the course of a trade or a business.
Rev. Rul. 74-373[18] also considered the issue of prepayment of foreign taxes on business profits. However, what should make this ruling of interest is that it did so in the context of multiyear payments. In the case at hand, a U.S. corporation that was transacting business in Peru was required to remit compulsory prepayments to the Peruvian Government which would be subsequently credited in equal parts against the U.S. corporation’s ultimate Peruvian income and complementary tax liabilities for the next eight years. Consistent with the substantive guidance hitherto discussed, the ruling held “that the payments [were] not taxes at the time of their payment since they [were] merely deposits against future liability for tax. However, the payments when actually applied as a credit[19] against a Peruvian tax that does qualify as an income tax within the meaning of section 901 of the Code, qualify as creditable income taxes for purposes of section 901.”[20]
An important implication of the guidance handed by Rev. Rul. 74-373 also relates back to our immediately preceding discussion regarding foreign source portfolio income. Specifically, though multiyear prepayments on non-business income are even more unlikely, they are not impossible and based on the treatment prescribed by Rev. Rul. 74-373 their apparent correct treatment, irrespective of whether or not a reasonable approximation, is that as a mere deposit against a future, rather than an immediate payment of a currently, creditable income tax liability.
Foreign Taxes Paid on Employment Income
U.S. taxpayers living and employed abroad are in an evidently grayer area of the law compared to their counterparts who are either earning only foreign source investment income at an arm’s length from the source country or deriving profits through a fixed place of business therein. Consider how Rev. Rul. 59-101[21] addressed the creditability of foreign taxes remitted via both withholding and estimated payments by wage earners in Puerto Rico. The taxpayers discussed in the ruling have a relatively simple set of facts as they are not mentioned as earning any additional streams of income from Puerto Rico (or foreign country) sources. The ruling held that both the withheld and the estimated foreign taxes were creditable during the U.S. tax year of payment to the extent that such amounts represented the taxpayers’ legal and actual tax liability.[22]
There is also at least one Generic Legal Advice Memorandum (“GLAM”)[23] which is, although not precedential,[24] highly instructive considering it pertains to foreign wage withholding tax when the taxpayer’s foreign fiscal year is at odds with his or her U.S. tax year. The GLAM concludes that a cash basis taxpayer can claim credits in the U.S. tax year within which the withholding occurs to the extent that the amount withheld does not exceed a reasonable approximation of the final amount of the taxes owed at the end of the taxpayer’s foreign fiscal year. This is instructive because it clarifies that it need not matter that the taxes paid during the U.S. tax year pertain to a foreign fiscal year with a different ending date. Rather, foreign wage withholding taxes “are creditable in the year paid, even if the allowable amount is not finally determined until a subsequent U.S. tax year in which the foreign tax year ends.”[25] The analysis contained therein also strongly suggests the allowance of creditability in the event of overwithholding of foreign taxes during the portion of the foreign fiscal year that coincides with the latter part of the first U.S. tax year followed by a corrective adjustment to underwithhold foreign taxes during the portion of the foreign fiscal year that coincides with the first part of the second U.S. tax year.
Notwithstanding, while any semblance of unambiguous guidance is welcomed, matters of taxation are rarely completely devoid of confounding elements. Consider that the exercise of employment, at least in the inbound context, constitutes a trade or business.[26] However, as evident from the guidance hitherto discussed, the exercise of employment is, at least in the foreign tax credit context, alienated from the constitution of a trade or business. One must also not ignore that the available guidance addresses taxpayers with very simple factual scenarios. In practice, it is not uncommon for taxpayers, particularly sophisticated ones, to earn multiple types of foreign source income items in countries with complex tax regimes.[27] This inevitably poses difficulties for even the most astute practitioners in judging the reasonability of their clients’ approximated final foreign tax liabilities. Though the calculation of a taxpayer’s estimated final foreign tax liability by an experienced local practitioner would likely constitute a reasonable approximation for purposes of U.S. creditability, it by no means guarantees that the ultimate foreign tax liability could not be at variance with the approximation. This can cause, for U.S. purposes, a foreign tax redetermination[28] event which then obligates taxpayers to amend their previously filed original U.S. tax returns.[29] To avoid the potential unnecessary administrative burdens and compliance costs of filing multiple tax returns for the same U.S. tax year, the prudent course of action appears to be to, whenever possible, advise the taxpayer to have him or her finalize (and file) their foreign tax returns before finalizing their original U.S. tax returns.
FINAL THOUGHTS
The determination of the accurate amount of contemporaneously paid foreign taxes for purposes of U.S. creditability is quite a bit more nuanced than what many compliance-oriented practitioners may suspect. The difficulty inherent in the determination stems from the unique way in which the law distinguishes the transaction from its temporal dimension. Whereas the IRS material suggests parity between the two, the law severs them, revealing how the non-authoritative guidance serves unwittingly as a curtain against the dynamism of the law. While it may be tempting to conclude that the extent of the relevant information provided in the IRS material ought to be sufficient in determining a tax return position, as we saw, such temptation can impel the tax professional to forgo something consequential in its implication. As our walk through the authoritative sources of tax guidance relevant to our query reveals, practitioners must remain ever vigilant knowing that even something seemingly as simple as determining a foreign tax payment amount can be highly fact-dependent and subject to keen professional judgment.
[1] See IRC § 901(a).
[2] Assuming that such individual did not elect to claim the foreign tax credit on an accrual basis pursuant to IRC § 905(a).
[3] Freedom of Information Act, 5 U.S. Code § 552.
[4] Instructions, Form 1116 (December 28, 2022), pg. 19.
[5] Referring to Form 1116 (2022), Part II—Foreign Taxes Paid or Accrued, pg. 1.
[6] Referring to Form 1116 (2022), Part I—Taxable Income or Loss From Sources Outside the United States, pg. 1.
[7] Supra note 5.
[8] Publication 514 (January 31, 2023), pg. 5.
[9] Ibid.
[10] Though not the subject, and outside of the scope, of this paper, it should be tangentially noted that this treatment is consistent with the tax accounting rules. See. Treas. Reg. §§ 1.446-1(c)(1)(i) and 1.461-1(a)(1).
[11] Supra note 6.
[12] Portfolio income generally includes gross income, other than that derived in the ordinary course of a trade or a business. See generally Temp. Treas. Reg. § 1.469-2T(c)(3).
[13] Rev. Rul. 57-516, 1957-2 C.B. 435.
[14] For a more targeted discussion on the tax treatment in such scenarios see Rev. Rul. 70-425, 1970-2 C.B. 151, discussed infra.
[15] Rev. Rul. 71-517, 1971-2 C.B. 268.
[16] Supra note 15.
[17] See also Rev. Ruls. 68-147, 1968-1 C.B. 338 and 68-318, 1968-1 C.B. 342.
[18] Rev. Rul. 74-373, 1974-2 C.B. 203.
[19] I.e., for Peruvian, not U.S., tax purposes.
[20] In this vein, see also New York & Honduras Rosario Mining Co. v. Commissioner, 168 F.2d 745 (2d Cir. 1948), wherein a New York corporation prepaid income taxes to cover a twenty year period. The Court decided that the sum advanced stood as a credit to the taxpayer and that the Court was concerned with the debits charged against such credit in those years. The debits, the Court held, were payments of income tax to a foreign country.
[21] Rev. Rul. 59-101, 1959-1 C.B. 189.
[22] See also Rev. Rul. 56-124, 1956-1 C.B. 97 which considers the issue of the deductibility of withheld and estimated payment amounts of Maryland state income taxes against the eventual tax liability resulting from a cash basis individual’s salary. The ruling references §§ 164(a) and 461(a) in allowing the deduction in the year of payment.
[23] GLAM 2008-05 (May 9, 2008).
[24] IRC § 6110(k)(3) denies written determinations precedential status but it is not entirely clear whether the nomenclature “precedent” connotes only “binding authority” or “persuasive authority” as well. Indeed, Courts have considered written determinations in formulating their judgments. See American Express Co. v. United States, 262 F.3d 1376 (Fed. Cir. 2001) and Western Company of North America v. United States, 323 F.3d 1024 (Fed. Cir. 2003).
[25] Supra note 24.
[26] IRC § 864(b); Treas. Reg. § 1.864-2(a).
[27] As a very convenient example, consider our very own U.S. tax regime that makes available various tax-advantageous preferences to various classes of taxpayers, imposes multiple types of income-based taxes, and applies varying graduated tax rates to different types of income.
[28] Treas. Reg. § 1.905-3(a).
[29] Treas. Reg. § 1.905-4.
View the galley version of this paper in PDF format: Closer Look at the Creditability of Contemporaneously Paid Foreign Taxes (TNI)