Corporation Taxation Foreign Tax Credit - Research Paper Example

Contents Contents 2 3 Introduction 4 Credit for Foreign Income Taxes 4 Limitationon Credit 6 Maximum Allowable Foreign Tax Credit 6 Carryback and Carryover of the Foreign Tax Credit 6 Claiming the Tax Credit or Deduction Each Year 7 Foreign Taxes not eligible for the Foreign Tax Credit 7 Foreign Source Income 8 Refunds and Adjustments 8 Corporate Foreign Tax Credit Situation in the US 9 Conclusion 12 Corporation Taxation – Foreign Tax Credit Abstract This paper reveals issues that are related to foreign tax credit on corporate bodies. The discussion covers quite a number of topics including credit for foreign income taxes, limitation on credit, maximum allowable foreign tax credit, carry-back and carryover of the foreign tax credit, claiming the tax credit or deduction each year, foreign taxes not eligible for the foreign tax credit, foreign source income, refunds and adjustments and corporate foreign tax credit situation in the US. These sub-topics are very relevant to the research paper on the above mentioned topic. It is important to note that the paper has comprehensively discussed these topics in order to paint a clear picture in relation to corporation taxation- foreign tax credit. Introduction According to About.com (1) corporation tax is the type of tax that is taxable on profits and capital gains which are taxable on organizations and limited companies. These business establishments include societies, associations, clubs, cooperatives, charities and other unincorporated institutions. Foreign tax credit on the other hand is described as a non-refundable tax credit accrued from income taxes given to a foreign government due to withholding foreign income tax (About.com, 1). This type of tax applies to any employee in a foreign country or has some investment income from a certain foreign country. About.com reveals that the IRS Tax Code (§§ 1116) is usually used to claim foreign tax credit. This is however with an exception of a taxpayer who qualified for the de minimize exception. This particular credit is also subjected to a deduction. The deduction is usually on domestic taxation. Foreign tax credit normally minimizes double tax burden. This situation is likely to occur in the event that both countries obtain taxes from the foreign source income where the income is generated. However, there are four tests which one requires in order to qualify for the foreign tax credit (Rousslang, 1). It follows that foreign tax credit cannot be more than a company’s tax liability multiplied by a certain percentage thus maximum allowable foreign tax credit. Carrying back of the foreign tax credit is a common practice especially when the credit is more than the maximum limit (About.com, 1). It is usually carried to the future or previous year depending on the situation. Credit for Foreign Income Taxes Irs.gov (1) reveals that income tax systems across the world are known to provide credit for similar income taxes that are usually paid to foreign countries. A limitation of credit is usually subjected to the kind of taxes which are of a similar nature to the taxed being credited. There are a number of rules that govern the eligibility of a tax credit. They include basis and nature of the levy; availability of a tax treaty between the two countries; form of payments; political influence; similarity of credit between the two countries; conditions relating to the levy and property or services that accompany the taxes. A typical example is the United States tax system which allows foreign tax credit on the basis of limitations. These limitations are usually in relation to compulsory levies on gross receipts or net income. The countries that require participating in boycotts are not awarded the credit. This exemption also applies to taxes that are subjected to services and goods according to the relevant taxing authority. In the UK, foreign tax credit is allowed on foreign tax similar to corporation tax; subject to limitations (Irs.gov, 1). This situation is provided for in the respective tax treaties. Canada is known to limit the credit by way of deductions in relation to gas or oil businesses (Rousslang, 1). A common observation has been that most tax systems across the world indicate the specific time when a foreign levy is eligible to receive credit. This has to be in accordance to the agreed requirements of the foreign tax credit. Rousslang further reveals that some tax systems offer credit simply because the tax can be taxed according to the existing domestic tax system. Other systems offer the credit on the basis of the time when the particular foreign item is being subject to income tax requirements. Some tax systems offer credit on the basis of recognition in their financial statements. The government plays a vital role when it comes to developing tax treaties. It is therefore expected that various countries across the world have different methods of approaching this issue. Limitation on Credit Many income tax systems have their way of limiting foreign tax credit. Studies reveal that limitation on domestic income tax is very common. The domestic income tax generated by a foreign source is usually taxed. The various subsets on which the limitation may be applied include by income, region or country, group member and the type of domestic tax (Norton, 1). Prior period taxes may reduce the amounts in excess of the above mentioned limitation. It could also apply to future taxes. To qualify for a foreign tax credit, one must have tax imposed on him or her; the tax ought to have been settled; the respective tax ought to be legal therefore a liability of foreign tax and finally it must be income tax. It is also important to mention that only war profits, excess profits and income taxes qualify for foreign tax credit. Maximum Allowable Foreign Tax Credit A standard rule has always been that a company/business’s tax credit cannot be more than its respective US tax liability. This is normally multiplied by a certain factor. This factor is obtained by dividing a company’s total foreign-source by the total worldwide income (Norton, 1). The various categories of income have to be considered especially when calculating the allowable amount. Wages and investment income are typical examples of such income categories. Carryback and Carryover of the Foreign Tax Credit It is a common occurrence to carryback any amount of foreign credit amount that is more than the predetermined maximum reflected by a certain business establishment. This amount could also be carried forward to a future year for instance the next ten tax years (IRS Tax Code, §§ 442). Different tax years have different carryover time frames. According to research, the carryover scheme was used by the US as a job creation initiative. Claiming the Tax Credit or Deduction Each Year Norton (1) asserts that it is possible for a corporate institution to register a claim about a foreign tax credit or deduction every year. One can take a deduction and a credit in successive years respectively. Another possibility is whereby a corporate body may choose to amend its tax returns within a period of ten years with respect to the original tax return due date. It is also important to note that corporations prefer credits to deductions. This preference is irrespective of the foreign tax rate exceeding the US tax rate. A common observation is that these companies are usually not able to credit all their foreign taxes. Compliance issues in relation to claiming a tax credit reveal that the volume of foreign tax should not necessarily match the volume or rather the amount of tax which the foreign country is withholding. It follows that a corporate body enjoys a reduced rate of foreign tax strictly according to the tax treaty signed between the US and another country (IRS Tax Code, §§ 1118). In the event that some amount of income is excluded, then foreign tax credit cannot be claimed. The IRS should be informed or notified in case a redetermination occurs. Relevant forms should therefore be filled and submitted to the relevant authorities at this point. Foreign Taxes not eligible for the Foreign Tax Credit As mentioned earlier, it should be noted that not all taxes are eligible for foreign tax credit. However, they may be subjected to foreign tax reductions. An example of such a tax is when a corporate body pays tax to a foreign country yet it does not legally owe it anything (Hmrc.gov.uk, 1). This includes the amounts that are to be refunded by a foreign country. No credit can be awarded when a business enterprise has outstanding penalties and interests. Others are taxes on foreign oil related income, excluded income, foreign mineral income, international operations on boycotts and that which one can only obtain a deduction that has been itemized. Tax credit is also not eligible to income generated from gas extraction and foreign oil companies (IRS Tax Code, §§ 2675). Another group which does not enjoy foreign tax credit is made up of sanctioned countries, countries with poor public, international or diplomatic relations. Corporations which withhold their stocks for a certain period of time do not also enjoy the tax credit. Foreign Source Income A country’s tax system is charged with the responsibility of distinguishing foreign and domestic sources of income (Rousslang, 1). Such systems are known to impose various limits on foreign tax credit on some income commonly referred to as foreign source income. It is for this reason that the system is made up of rules used to define domestic and foreign income sources. The rules vary from simple to complex. The rules vary from one country to another. The US defines a source of income on the basis of gross income, expenses and deductions as compared to Canada. Canada determines the source of income of a particular corporate body in relation to its nature. Refunds and Adjustments According to Rousslang (1) many tax systems across the world are characterized by comprehensive corrective structures in the event that the status of the foreign tax credit changes. These changes could be due to a number of factors including losses, tax credits, tax adjustments, carrybacks due to deductions and changes in examination returns. It is for this reasons that refunds and adjustments are incorporated to balance the situation. According to IRS Tax Code (§§ 7601) the US has set rules that govern the process of refunds and adjustments. It follows that there are adjustments relating to corporate bodies (taxpayers); adjustments relating to the deemed paid taxes and adjustments which have no effect in terms of reducing the country’s tax volume. The taxpayers in the first category are expected to effect amendments on tax returns. They either pay or claim a refund for the tax difference. The second type of adjustment is only applicable to corporate bodies in the US (Rousslang, 1). They are therefore expected to reduce the volume of taxes in addition to advising the government on relevant matters. The taxpayers affected by the final category of adjustments are charged with the responsibility of also advising the government on issues of foreign tax credit including carryovers. Corporate Foreign Tax Credit Situation in the US Irs.gov (1) asserts that the US corporations and individuals alike are entitled to foreign tax credit. However, the major bulk of the credit is enjoyed by the corporations. The country employs a simple system or rather concept in relation to foreign tax credit (IRS Tax Code, §§ 545). The US uses a global tax system which relates to residence principle and taxes on income earned abroad. A tax credit is usually awarded on the foreign income taxes so as to avoid incidences of double taxation. The foreign source income in this context includes the wages that are generated abroad. A common observation is that these corporations obtain foreign source income from branches that are established abroad (Irs.gov, 1). Some of these corporations have incorporated affiliates abroad. This kind of income is automatically a subject of the United States tax system. In this case, the tax year in which the respective credit was earned is very significant. Hmrc.gov.uk (1) reveals that the product of the US tax rate and the respective branch’s income is known as the tentative U.S. tax. Tax credit is usually offered to the foreign withholding taxes and income taxes levied when the branch generates taxable income to its parent company in the US. To lower the corporation’s US income tax, the losses incurred by a foreign branch are usually deducted from the domestic income of the respective corporation. In relation to IRS Tax Code (§§ 3245) There is usually no room to claim for a foreign tax credit in the event that a corporation’s branch incurs significant profits in successive years. It follows that the income will be treated as a source of income to the United States as a country. This situation prevails until the country’s treasury recovers the tax reductions due to the initial losses incurred by the branch in question. In the event that the income is obtained from an affiliate (foreign) branch, the income is only subject to the US tax system since it was initially generated as dividends for the parent corporation in the United States. Until earnings are repatriated, the US tax on unremitted earnings is usually deferred (Irs.gov, 1). The benefits of tax deferring work in favor of the corporation. It is mandatory for the parent corporation to own at least ten percent of the affiliate so as to enjoy foreign tax credit. This kind of foreign affiliate is commonly referred to as a foreign subsidiary. It therefore works to channel dividends to the parent corporation in the United States. These dividends are usually generated from profits and earnings after deducting foreign income taxes. The formula used to determine the foreign tax credit and tentative tax is based on variables like dividends (D), the US tax (tUS) and the foreign income tax rate (tF) (IRS Tax Code, §§ 785). The foreign income tax rate is used to determine the foreign tax credit. The sum of the total foreign income taxes collected and the foreign withholding taxes is subtracted from the tentative US tax. A positive result means that the respective corporation owes the US government a residual tax. Otherwise, the corporation is said to have foreign tax credits that are in excess. According to Irs.gov (1) the US Corporation has the responsibility to sum up the foreign taxes and source income from all its affiliates, subsidiaries and branches. This initiative enhances the calculation of residual US tax and the respective foreign tax credit. The IRS Tax Code (§§ 1145) defines an income basket where these two aspects can be grouped together as long as the foreign source income is within the same income category. The major income baskets encompass financial services income, passive income, general limitation income and shipping income (Rousslang, 1). The various income baskets are usually subjected to different or rather separate foreign tax limitation. The idea of having separate income baskets works to discourage corporations from relocating their highly mobile offshore investments when they can actually be established in countries with low tax rates. The IRS Tax Code (§§ 6320) does not advocate for income deferral. However, the US corporations can still enjoy incentives on tax to enable them to locate their establishments abroad such that they are free to combine foreign taxes and income generated from their investments. In the US, a large percentage of the tentative tax is usually offset by foreign tax credit. A total of 174.6 billion dollars of taxable income was realized in the year 2000 (Irs.gov, 1). The foreign taxes on this amount reached the 61.5 billion dollar mark whereby 48.4 billion dollars was creditable. According to Hmrc.gov.uk (1) the residual US tax amounted to 12.7 billion US dollars. 90 billion US dollars worth of foreign tax credits were recorded in 2005. This amount included both corporate and individual tax returns. Conclusion As discussed in the paper, foreign tax credit is a very important factor when running corporate businesses. It is therefore wise to understand the tax system of a country before investing. Such initiatives help to save significant resources in terms of time and money. Currently, many countries across the globe experience simultaneous events of capital inflows and outflows. Common knowledge dictates that domestic income maximization and national neutrality are enhanced by foreign tax deductions. However, recent studies have revealed that foreign tax credit after all is not the best policy that can be used to maximize global income. Works Cited About.com. “Foreign Tax Credit or Deduction”. 26 Apr. 2011. Web. 16 Oct. 2011 http://taxes.about.com/od/taxhelp/a/ForeignTaxCred.htm. Cornell.edu. “Legal Information Institute: Internal Revenue Code”. 01 Feb. 2010. Web. 20 Oct. 2011 Hmrc.gov.uk. “Introduction to Corporation Tax”. 17 Jul. 2010. Web. 24 Oct. 2011 Irs.gov. “Foreign Tax Credit”. 23 Sep. 2011. Web. 21 Oct. 2011 . Norton, Rob. “Corporate Taxation”. Econlib.org. 25 May 2008. Web. 25 Oct. 2011 . Rousslang, Donald. “Foreign Tax Credit”. Taxpolicycentre. 15 Jan. 2011. Web. 24 Oct. 2011 . Read More