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How reduced rates for capital gains and qualified dividends affect the FTC.

EXECUTIVE SUMMARY

* With reduced rates on capital gains and dividends, it is more likely that a taxpayer's foreign taxes win exceed the FTC limit.

* Taxpayers with capital gains and/or dividends taxed at a reduced rate are required to adjust the maximum FTC calculation.

* Tax advisers should check whether their software is calculating the maximum FTC credit for both regular tax and AMT purposes.

Reduced rates for capital gains and qualified dividends affect the maximum allowable foreign tax credit (FTC) for many taxpayers. This article explains in detail how such reduced rates influence the FTC computation.

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This article is an overview of the effect of reduced tax rates on capital gains and/or qualified dividends on the maximum allowable foreign tax credit (FTC) for individuals. Specifically, it addresses the (1) mechanics of the adjustment made to the maximum allowable FTC; (2) reasoning behind the percentages used for the adjustment; (3) adjustment's effect on the alternative minimum tax (AMT); (4) changes in FTC carryback and carryforward rules; (5) advantages and disadvantages of claiming a deduction versus a credit for foreign taxes paid; (6) de minimis exemption to the FTC limitation; and (7) status of software programs and the calculation of the maximum allowable FTC.

Basic FTC Computation

The basic premise behind the FTC is to provide relief from double taxation of income from foreign sources. Under Sec. 904(a), the credit is limited to the taxes that would have been paid to the U.S. on foreign-source income. The maximum allowable credit is the proportion of an individual taxpayer's foreign-source taxable income over the taxpayer's total U.S. taxable income before deducting personal and dependency exemptions, multiplied by the taxpayer's U.S. income tax before any tax credits. In other words, it is the taxpayer's average Federal tax rate multiplied by the taxpayer's foreign-source taxable income. For example, if a taxpayer has $40,000 of foreign-source income, $150,000 of U.S. taxable income before exemptions and $30,000 of U.S. income tax before any tax credits, the maximum allowable credit is $8,000 (($40,000/$150,000) x $30,000). The $150,000 of U.S. taxable income is worldwide income and includes the $40,000 of foreign-source income.

The calculation of the maximum allowable FTC is rather simple, until the reduced income tax rates on capital gains and/or qualified dividends are considered. Although a lower tax rate on capital gains has existed for many years, the reduction of the individual income tax rates on qualified dividends to 15% (5% if the taxpayer is in the 10% or 15% income tax bracket) by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) has substantially increased the probability that tax practitioners will be confronted with this calculation. (1)

Adjustment to Maximum Allowable FTC

If taxpayers' capital gains and/or qualified dividends are taxed at a reduced rate, they are required to adjust the numerator (foreign-source taxable income) and/or denominator (U.S. taxable income before exemptions) for purposes of the maximum allowable credit calculation, under Sec. 904(b) (2)(B). They have to adjust only the denominator if their foreign-source income was not taxed at a reduced rate. They have to adjust both the numerator and the denominator if all or a portion of their foreign-source income was taxed at a reduced rate. Some type of adjustment is made regardless of the origin of the reduced tax rates for capital gains and/or qualified dividends. For example, a taxpayer with no foreign-source income that qualifies for reduced tax rates is still required to adjust the denominator if the taxpayer's domestic capital gains and/or qualified dividends were taxed at a lower rate.

Although the FTC adjustment calculation is fairly complex, the reason for the adjustment is to ensure that taxpayers do not receive an FTC greater than the Federal income taxes paid on the foreign-source income. Thus, if the foreign-source income is from capital gains and/or qualified dividends taxed at the reduced U.S. income tax rates, the adjustment ensures that the maximum allowable credit does not exceed the reduced income tax as a result of those rates. In contrast, if the foreign-source income is ordinary income taxed at regular income tax rates, the adjustment ensures the maximum allowable credit is based on the taxpayer's regular income tax rates, rather than the reduced tax rates on capital gains and/or qualified dividends.

Adjustment Calculation

Exhibit 1 on p. 416 illustrates the calculation and how an adjustment to the numerator and/or denominator ensures the taxpayer does not receive an FTC greater than the Federal income taxes paid on the foreign-source income. An adjustment calculation worksheet is provided by the IRS in the 2005 Instructions to Form 1116, Foreign Tax Credit; see p. 17 (worksheet for line 17).

Exhibit 1: A comparison of columns 1, 2 and 3 of Exhibit 1 illustrates the effect of the adjustment on the numerator and/or denominator. Column 2 adjusts only the denominator to negate the effect of the reduced tax rate on the qualified domestic dividend income. Column 3 adjusts both the numerator and denominator to provide a substantially lower allowable FTC, to ensure the taxpayer receives an FTC for the U.S. taxes paid on the foreign-source income at 15%. Thus, these adjustments are made solely to ensure that the maximum allowable FTC is limited to the taxes that would have been paid to the U.S. on the foreign-source income.

In Exhibit 1, the taxpayer has total foreign taxes paid of $12,000 on $30,000 of foreign-source income, qualified domestic dividend income of $5,000 taxed at 15%, and other domestic income of $45,000 taxed at an ordinary income tax rate of 35%. Column 1 of Exhibit 1 makes no adjustment to either the numerator (line 2) or denominator (line 5), as required by law. Column 1 is presented solely as a baseline measure to illustrate the adjustment's effect on the numerator and/or denominator.

Column 2 of Exhibit 1 assumes the foreign-source income is ordinary income taxed at an income tax rate of 35%. Because the foreign-source income is taxed at ordinary income tax rates in column 2, the numerator (foreign-source income) is not adjusted on line 2, but the denominator (taxable income before exemptions) is adjusted on line 5. The adjustment factor for line 5 is from p. 17 (worksheet for line 17) of the instructions to Form 1116.

The maximum allowable FTC in column 2 (line 9) is $10,500. It is no coincidence that the foreign-source taxable income of $30,000 times the ordinary income tax rate of 35% also equals $10,500. Thus, column 2 of Exhibit 1 illustrates the basic premise that the maximum allowable FTC is the amount of taxes that would have been paid in the U.S. on the foreign-source income. Importantly, the maximum allowable credit in column 2 ($10,500) is greater than the credit in column 1 ($10,125), because the adjustment to the denominator in column 2 (line 5) negates the effect of the reduced taxes rates on the qualified domestic dividend income.

Column 3 of Exhibit 1 assumes that the foreign-source income is qualified dividend income taxed at 15%. Because the foreign-source income is taxed at a reduced rate in column 3, the numerator (foreign-source taxable income) is adjusted on line 2 and the denominator (taxable income before exemptions) is also adjusted on line 5. The factors for these adjustments also come from the instructions to Form 1116. Importantly, the maximum allowable FTC in column 3 (line 9) is $4,500, which equals the foreign-source taxable income of $30,000 times the reduced tax rate on dividends of 15%.The maximum allowable credit in column 3 ($4,500) is significantly less than the credit in column 1 ($10,125), because the credit in column 1 considers the $45,000 of other domestic income taxed at an ordinary income tax rate of 35%. The maximum allowable credit does not consider this other domestic income; the credit is limited to the amount of taxes that would have been paid to the U.S. on the foreign-source qualified dividend income.

The adjustment to the numerator in column 3 (line 2) of Exhibit 1 for the qualified dividend income taxed at 15% is required only for certain taxpayers. An adjustment to the numerator is not required if taxpayers have less than $20,000 of foreign-source net capital gains and foreign-source qualified dividends taxed at a reduced tax rate and if their taxable income less net capital gain income and qualified dividends (line 7 of the qualified dividends and capital gains worksheet) does not exceed certain amounts ($182,800 if married filing jointly (MFJ) or qualified widow(er), $91,400 if married filing separately, $150,150 if single or $166,450 if head of household for 2005). Thus, for Exhibit 1, the adjustment to foreign-source taxable income on line 2 of column 3 is not required if the foreign-source qualified dividend income is less than $20,000. This adjustment exemption can provide a tremendous benefit to taxpayers. As noted in Exhibit 1, the maximum allowable FTC with the numerator adjustment is $4,500 (column 3, line 9). If the numerator is not adjusted, the maximum allowable FTC for column 3 is $10,500 (calculation not presented). Thus, if the exemption for the numerator adjustment increases to $30,000 to cover the example, the maximum allowable credit would increase by $6,000.

Reasoning Behind Adjustment Percentages

As noted in the instructions to Form 1116, the percentage adjustment for 28%, 25% and 15% gains for individual taxpayers is 0.2000, 0.2857 and 0.5714, respectively. These percentages are calculated under Sec. 904(b)(3)(E) by taking the difference between the maximum tax rate on ordinary income (35%) and the income tax rate on that particular class of income and dividing this difference by the maximum tax rate on ordinary income. The ratio for each type of gain is calculated as follows:

28% gain: (0.35 - 0.28)/0.35 = 0.2000

25% gain: (0.35 - 0.25)/0.35 = 0.2857

15% gain: (0.35 - 0.15)/0.35 = 0.5714

These different ratios ensure that the maximum allowable FTC is based on the appropriate tax rate. Exhibit 2 on p. 418 illustrates how the maximum allowable FTC should remain the same, regardless of the reduced tax rate on the qualified domestic income (i.e., 28% in column 1 and 25% in column 2). The only difference between columns 1 and 2 of Exhibit 2 is that the qualified domestic income is taxed at 28% and 20% in columns 1 and 2, respectively. The use of different adjustment factors in step 5 of Exhibit 2 allows the maximum allowable FTC to remain the same. As noted in step 9 of Exhibit 2, the maximum allowable FTC is $10,500 in both columns 1 and 2. Once again, it is no coincidence that the foreign-source income of $30,000 multiplied by the ordinary income tax rate of 35% also equals $10,500. Thus, the different ratios (i.e., 0.2000 for the 28% tax rate and 0.2857 for the 25% tax rate) for the qualified domestic income ensure that the maximum allowable credit remains the same.

Effect on AMT

Because the reduced tax rates on capital gains and qualified dividends are the same for regular tax and the AMT, the adjustment calculation is the same for the AMT, under Sec. 904(b) (3)(E)(iii). As with the calculation for regular income tax, if a taxpayer's foreign-source income was not taxed at a reduced rate, the taxpayer is required to adjust only the denominator (alternative minimum taxable income (AMTI)) for the AMT under Sec. 904(b)(2)(B)(ii). Likewise, if all or a portion of the taxpayer's foreign-source income was taxed at a reduced rate, the taxpayer is required to adjust both the numerator (taxpayer's foreign-source AMTI) and the denominator (AMTI) for the AMT; see Sec. 904(b)(2)(B). The factors used are the same for regular tax and AMT.

Changes in Carryback and Carryforward Rules

With the reduced tax rates on capital gains and qualified dividends, a taxpayer has a higher probability that the amount of foreign taxes paid will exceed the overall limit for the year under Sec. 904(a). Although FTCs can still be carried over, the carryover rules for FTCs have changed the carryback and carryforward periods. Prior to Oct. 23, 2004, the excess could be carried back to the two preceding tax years and then forward to the five succeeding tax years. The American Jobs Creation Act of 2004 modified the carryback and carryforward periods for foreign taxes. After Oct. 22, 2004, the carryback period is reduced to one year, while the carryforward period has been extended to 10 years for both existing and future carryforwards under Sec. 904(c).

Deduction Versus Credit

Most tax practitioners recognize that a taxpayer may claim a deduction or a credit for foreign income taxes paid on foreign-source income under Sec. 275(a)(4)(A). In most instances, the FTC is more advantageous, because it provides a direct offset against the Federal tax liability, and a deduction is available only to taxpayers who itemize. However, with the reduced tax rates on capital gains and/or qualified dividends, an itemized deduction for foreign taxes paid on foreign-source income might be more advantageous. For example, if a taxpayer's foreign-source dividends are taxed at 40% in the foreign country and these dividends are taxed at 15% for Federal tax purposes, it is likely that the taxpayer will have a large amount of foreign income taxes that will be unallowed as an FTC for Federal tax purposes (i.e., the unallowed portion being the difference between the 40% foreign tax rate and the 15% Federal tax rate). If the reduced tax rates stay in effect for over 10 years, the unallowed foreign taxes may go unused and expire; with the carryback period limited to one year, the FTC carryforward period would expire without the taxpayer getting any benefit from the foreign taxes paid. It is also important to remember that most states allow a deduction, but not a credit, for foreign taxes paid. Thus, when determining whether to claim a deduction or a credit for foreign taxes paid, it is important to consider the effect of a taxpayer's marginal state income tax rates.

A taxpayer elects to claim a credit for foreign taxes paid on an annual basis by filing Form 1116. Under Sec. 6511(d)(3), the election to claim a credit or deduction can be changed as long as the statute of limitations for the year in question remains open. Thus, tax practitioners should consider reviewing their clients' 2003 and 2004 income tax returns to determine whether the election to claim a credit or deduction produced the most advantageous tax result.

Foreign taxes paid are deductible for regular tax, but are not deductible if the taxpayer is subject to the AMT. When determining whether to claim a credit or deduction, tax practitioners should consider whether the taxpayer is likely to be subject to the AMT.

De Minimis Exemption

Because of these rules, the IRS has offered some relief to taxpayers with minimal foreign taxes. The de minimis exemption under Sec. 904(j) allows taxpayers with $300 or less of foreign taxes ($600 if MFJ) to be exempt from the FTC limit, provided they have no foreign-source income other than qualified passive income. Importantly, the exemption is not automatic. To qualify, a taxpayer must elect to take the exemption by taking the credit directly on Form 1040. This election must be made in each year that the taxpayer qualifies. Under Sec. 904(j)(1)(B) and (C), a taxpayer electing the de minimis exemption may not carry back or carry forward excess foreign taxes to a year in which he or she has elected the de minimis exemption. The carryback and carryforward are not available, because the purpose of the exemption is to provide relief from the complexity of the calculation related to the FTC.

Software Programs

Tax practitioners should ensure that their software is calculating the maximum allowable FTC correctly for both regular tax and the AMT. Because these calculations are relatively new, certain programs could be calculating these amounts incorrectly. Some manufacturers may have corrected the problem for 2005. Tax practitioners should carefully review Form 1116, especially when foreign-source income is taxed at reduced rates that require an adjustment to the numerator (taxpayer's foreign-source taxable income). Practitioners can manually calculate the maximum allowable credit using the step-by-step calculations in Exhibit 1, and compare these calculations to the output of their software programs.

Conclusion

If a taxpayer's capital gains and/or qualified dividends are taxed at a reduced rate, the taxpayer is required to adjust the numerator (foreign-source taxable income) and/or denominator (U.S. taxable income before exemptions) for purposes of the maximum allowable FTC calculation. However, even a taxpayer with no foreign-source income that qualifies for reduced income tax rates is required to make an adjustment if his or her domestic capital gains and/or qualified dividends were taxed at a reduced rate. These adjustments ensure that the maximum allowable FTC is limited to the taxes that would have been paid to the U.S. on the foreign-source income. At face value, the calculation of the maximum allowable FTC is fairly simple. However, the issues discussed in this article illustrate just how complex the calculation of the limit on the FTC can be.

(1) See Secs. 904(b)(1), 1(h)(11)(A), 1(h)(11)(B) and 1(h)(11)(C)(iv).

Thomas E. Vermeer, Ph.D., CPA

Associate Professor of Accounting

University of Baltimore

Baltimore, MD

Phillip J. Korb, MS, CPA

Associate Professor of Accounting

University of Baltimore

Baltimore, MD

John N. Sigler, J.D., CPA

Associate Professor of Accounting

University of Baltimore

Baltimore, MD
Exhibit 1: Effect of reduced tax rates on capital gains and/or
qualified dividends on the maximum allowable FTC

Facts:

1. Total foreign taxes paid of $12,000 on $30,000 of foreign-source
income.

2. Qualified domestic dividend income of $5,000 taxed at 15%.

3. Other domestic income of $45,000 taxed at an ordinary income tax
rate of 35%.

 (Column 1)
 Maximum credit
 allowed with neither
 the numerator nor
 denominator adjusted
 for qualified
 dividends (a)

 1. Taxable income from foreign source $30,000

 2. Adjustment to numerator for foreign-source 0
 income taxed at reduced rates

 3. Adjusted foreign-source taxable income $30,000

 4. Taxable income before exemptions $80,000
 (line 41, Form 1040)
 ($30,000 + $5,000 + $45,000)

 5. Less: adjustment for reduced dividends $0

 6. Adjusted taxable income after adjustment $80,000
 (line 4 - line 5)

 7. Percentage of total income from foreign 0.375
 source (line 3 / line 6)

 8. Total tax before credits (line 44, $27,000 (b)
 Form 1040)

 9. Maximum allowable credit $10,125
 (line 7 x line 8)

10. Foreign taxes paid $12,000

11. Allowed FTC $10,125
 (lesser of line 9 or line 10)

 (Column 2)
 Maximum credit
 allowed foreign-
 source income is
 taxed at ordinary
 income tax rate
 of 35%

 1. Taxable income from foreign source $30,000

 2. Adjustment to numerator for foreign-source 0 (c)
 income taxed at reduced rates

 3. Adjusted foreign-source taxable income $30,000

 4. Taxable income before exemptions $80,000
 (line 41, Form 1040)
 ($30,000 + $5,000 + $45,000)

 5. Less: adjustment for reduced dividends (2,857) (d)

 6. Adjusted taxable income after adjustment $77,143
 (line 4 - line 5)

 7. Percentage of total income from foreign 0.3889
 source (line 3 / line 6)

 8. Total tax before credits (line 44, $27,000 (b)
 Form 1040)

 9. Maximum allowable credit $10,500
 (line 7 x line 8)

10. Foreign taxes paid $12,000

11. Allowed FTC $10,500
 (lesser of line 9 or line 10)

 (Column 3)
 Maximum credit
 allowed foreign-
 source income is
 qualified dividends
 taxed at 15%

 1. Taxable income from foreign source $30,000

 2. Adjustment to numerator for foreign-source (17,142) (e)
 income taxed at reduced rates

 3. Adjusted foreign-source taxable income $12,858

 4. Taxable income before exemptions $80,000
 (line 41, Form 1040)
 ($30,000 + $5,000 + $45,000)

 5. Less: adjustment for reduced dividends (19,999) (f)

 6. Adjusted taxable income after adjustment $60,001
 (line 4 - line 5)

 7. Percentage of total income from foreign 0.2143
 source (line 3 / line 6)

 8. Total tax before credits (line 44, $21,000 (g)
 Form 1040)

 9. Maximum allowable credit $4,500
 (line 7 x line 8)

10. Foreign taxes paid $12,000

11. Allowed FTC $4,500
 (lesser of line 9 or line 10)

(a) This calculation assumes that the foreign-source income is ordinary
income taxed at ordinary income tax rates. It also makes no adjustment
to either the numerator or denominator, as is required under the law.
It is presented solely for comparative purposes.

(b) ($75,000 x 0.35) + ($5,000 x 0.15) = $27,000.

(c) No adjustment is made to the numerator, because the foreign-source
income is taxed at ordinary income tax rates.

(d) $5,000 x 0.5714 = $2,857. This adjustment factor comes from p.17
(worksheet for line 17) of the 2005 instructions to form 1116.

(e) $30,000 x 0.5714 = $17,142. An adjustment is made to the numerator
because the foreign-source income was taxed at a reduced rate.

(f) ($5,000 + $30,000) x 0.5714 = $19,999.

(g) ($45,000 x 0.35) + ($35,000 x 0.15) = $21,000.

Exhibit 2: Maximum credit allowed with qualified domestic income taxed
at different tax rates

Facts:

1. Total foreign taxes paid of $12,000 on $30,000 of foreign-source
income taxed at ordinary income tax rate of 35%.

2. Qualified domestic income of $5,000 taxed at a different rate.

3. Other domestic ordinary income of $45,000 taxed at a 35% rate.

 (Column 1)
 Maximum credit
 allowed with
 qualified domestic
 income taxed
 at 28%

 1. Taxable income from foreign source $30,000

 2. Adjustment to numerator for foreign-source 0
 income taxed at reduced rates

 3. Adjusted foreign-source taxable income $30,000

 4. Taxable income before exemptions $80,000
 (line 41, Form 1040)
 ($30,000 + $5,000 + $45,000)

 5. Less: adjustment for reduced tax rate
 on domestic income
 ($5,000 x 0.2000) ($1,000) (a)
 ($5,000 x 0.2857)

 6. Adjusted taxable income after adjustment $79,000
 (line 4 - line 5)

 7. Percentage of total income from foreign 0.3797
 source (line 3 / line 6)

 8. Total tax before credits (line 44,
 Form 1040)
 ($75,000 x 0.35) + ($5,000 x 0.28) $27,650
 ($75,000 x 0.35) + ($5,000 x 0.25)

 9. Maximum allowable credit $10,500
 (line 7 x line 8, rounded up)

10. Foreign taxes paid $12,000

11. Allowed FTC $10,500
 (lesser of line 7 or line 8)

 (Column 2)
 Maximum credit
 allowed with
 qualified domestic
 income taxed
 at 25%

 1. Taxable income from foreign source $30,000

 2. Adjustment to numerator for foreign-source 0
 income taxed at reduced rates

 3. Adjusted foreign-source taxable income $30,000

 4. Taxable income before exemptions $80,000
 (line 41, Form 1040)
 ($30,000 + $5,000 + $45,000)

 5. Less: adjustment for reduced tax rate
 on domestic income
 ($5,000 x 0.2000)
 ($5,000 x 0.2857) ($1,429)

 6. Adjusted taxable income after adjustment $78,000
 (line 4 - line 5)

 7. Percentage of total income from foreign 0.3818
 source (line 3 / line 6)

 8. Total tax before credits (line 44,
 Form 1040)
 ($75,000 x 0.35) + ($5,000 x 0.28)
 ($75,000 x 0.35) + ($5,000 x 0.25) $27,500

 9. Maximum allowable credit $10,500
 (line 7 x line 8, rounded up)

10. Foreign taxes paid $12,000

11. Allowed FTC $10,500
 (lesser of line 7 or line 8)

(a) The adjustment factors come from p. 17 (worksheet for line 17) of
the 2005 instructions to Form 1116.
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Title Annotation:foreign tax credit
Author:Sigler, John N.
Publication:The Tax Adviser
Date:Jul 1, 2006
Words:4032
Previous Article:Tax accounting issues for foreign trusts.
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