Effect of NOL carryovers on FTC.

In the U.S., domestic corporations are taxed on their worldwide income. Regardless of geographical source, the entire income of these taxpayers generally is subject to U.S. income tax, raising problems of international double taxation. To provide relief from double taxation, the U.S. allows a deduction for foreign taxes in computing gross income. Additional relief comes from the foreign tax credit (FTC). Under Sec. 901, domestic corporations (at their option) may credit rather than deduct foreign income taxes.

However, the Code imposes limits on the amount of the allowable FTC. Sec. 904(a) provides that the FTC cannot exceed the same proportion of the tax for which the credit is taken that the taxpayer's foreign-source income bears to worldwide taxable income, as follows:

FTC Limitation:

Creditable foreign tax =

U.S. income tax x Foreign-source income/Worldwide taxable income

In practice, a question often arises about the effect of the FTC limit on "preserving" the source of a net operating loss (NOL) when a domestic corporation carries back or forward an NOL.

It appears that the source should be preserved. In a carryover year, the NOL loss deduction should be allocated only to the gross income of the country in which the loss occurred, regardless of whether there is sufficient taxable income from the country in the year to absorb the loss. Simply put, the loss incurred in the year of the overall NOL should be treated as if incurred in the carryover year.

GCM 39555 (which applied the principles of Regs. Sec. 1.861-8(e)(8) and Rev. Ruls. 69-121 and 71-432) seems to support this conclusion. GCM 39555 discussed the example of a domestic corporation with foreign-source income in 19xx of $300x, domestic-source income of $50x and an NOL carryforward of $200x; the latter was attributable to a domestic loss in the year in which the NOL was created. For purposes of computing the FTC limit, no portion of the NOL deduction was apportioned to the foreign-source income numerator, because it was attributable in full to a domestic loss in the year in which the NOL arose. The rationale for this conclusion was that, "but for" the foreign-source income of $300x, the domestic corporation's NOL deduction would have been limited to only the domestic-source income of $50x.

Further, support may be found in Motors Insurance Corp., 530 F2d 864 (1976), in which the Court of Claims ruled that a carryback of an NOL deduction mandated the recomputation of both the numerator and denominator in the fraction of the prior year's FTC limit. The court also ruled that the NOL deductions must be allocated directly to the income generated in the prior carryback years from the same geographical sources.

The court's reasoning related to the purpose of the carryover provisions, namely, to do away with the normal rigors of the one-year accounting system. Allocation of the carryover deductions would depict more accurately a domestic corporation's income from both foreign and domestic sources. Therefore, the NOL carryback deductions should be allocated to the year of the prior carryback from the geographical sources that later engendered the losses.

FROM PETER CROCCO, JR., CPA, NEW YORK, NY

Robert Zarzar, CPA
Partner
Washington National Tax Services
PricewaterhouseCoopers
Washington, DC