Latest developments: Use the foreign tax credit against net investment income tax liability
An important tax case was decided recently in the Court of Claims. The IRS lost and the taxpayer won, which always makes my little heart skip a beat with happiness.
The case is Christensen v. United States. Warning: the opinion is 48,000+ words long. It’s a book.
The IRS has always said you can only use foreign tax credit to offset U.S. income tax liability. You cannot use foreign tax credit against your net investment income tax liability.
An American couple living in France sold stock. The capital gain tax of 30% was paid in France. They then sought to use the foreign tax credit to offset the 20% U.S. income tax on the long term capital gain (allowed, said the IRS) and to offset the 3.8% U.S. net investment income tax on that capital gain (rejected, said the IRS).
The judge ruled for the taxpayer – French capital gain tax was allowed to be used as a foreign tax credit against their net investment income tax liability. The income tax treaty between the United States and France allows it.
Federal tax law is made of two separate, parallel universes: the Internal Revenue Code and any applicable treaty. The rules agree sometimes, and sometimes the treaty rules override the result that you would otherwise expect under the Internal Revenue Code.
The result: U.S. citizens living in France can use the USA/France income tax treaty to use French income tax paid to offset U.S. net investment income tax.
The takeaways for you:
- If you have an American client living in France (and paying tax!), you should look at the treaty to claim a foreign tax credit to apply to the net investment income tax liability – and look at the Christensen opinion to see how to do it.
- If you are preparing income tax returns for an American living abroad in another country that has an income tax treaty, look carefully at the treaty to see if the logic of the Christensen case will apply. Every treaty is subtly different. I haven’t looked at any other treaties to see if they might apply. But it’s worth a look when the opportunity arises.
“What is column (h) in Schedule P used for?”
OK. Enough of the preliminaries. Now, onward to the main event.
A friend (shoutout to Anne) asked this question in the last Form 5471 Series episode (the one about distributions).
In the chat box I asked what makes the difference on Schedule P, Column (d) and Column (h). Another participant responded that column (d) would relate to amounts reclassified from 959(c)(3) on Line 7. I can see that. But what is Column (h) ever used for? When would we have Sec 951A PTEP which has *not* been reclassified from previously untaxed Sec 959(c)(3) E&P?
Anne’s puzzlement is legit:
- Column (d)’s heading says: “Reclassified section 951A PTEP”
- Column (h)’s heading says “Section 951A PTEP”
What’s the difference?
If you feel like you just sat down to an exam for a class you forgot you registered for, you’re not alone.
Schedule E-1 = Schedule J = Schedule P
Three schedules for Form 5471 that contain earnings and profits data. (Well, four schedules if you want to count Schedule H for Current Earnings and Profits).
All three schedules have 10 columns of E & P data. The column headings are the same, but the column number is different in each.
- Schedule E-1 (Taxes Paid, Accrued, or Deemed Paid on Earnings and Profits (E&P) of Foreign Corporation),
- Schedule J (Accumulated Earnings & Profits (E&P) of Controlled Foreign Corporation), and
- Schedule P (Previously Taxed Earnings and Profits of U.S. Shareholder of Certain Foreign Corporations).
Why 10 columns? Where did they come from? What should you put into each column?
Where to find the law
One of the fantastic “aha!” moments of my tax career was when I realized that almost every item on a tax return can be – with a bit of effort – traced back to a precise Code section or Regulation. The IRS didn’t put stuff on tax forms to troll you. There is a reason for every item.
This creates a feedback loop that helps me unpuzzle myself. I can start with a tax return and when confused with “What goes on line 8?” I can work backwards to find the law and solve my problem. Or if I am dreaming up some clinically brilliant scheme, I can start with the law and go find exactly where the results of my brilliance will end up. Tax returns are how you talk to the government about money. You don’t want your clever tax strategy to create an incoherent mess on your client’s income tax return.
But I digress.
Let’s go find the relevant Regulation. When we do, we will find – to no one’s surprise – that the column headings on those three schedules are lifted word-for-word from definitions in the Regulations. That’s how we are going to figure out the answer to Anne’s question: does her section 951 PTEP go in column (d) or column (h)?
Schedules J and P are historical long-term earnings and profits trackers and they are important, but any time a form touches money (i.e., tax liability) you know it’s really important. The clue for figuring this out comes from the fact that earnings and profits are tied to foreign tax credit on Schedule E-1.
The foreign tax credit involved here is the “indirect” or “deemed paid” foreign tax credit of IRC §960.
Usually, you can only claim a foreign tax credit if you yourself paid the foreign income tax.
But IRC §960 allows a domestic corporation to claim a foreign tax credit for foreign income taxes paid by a CFC of which the domestic corporation is a United States shareholder. Someone else (the subsidiary) paid the income tax, yet the U.S. parent company claims the foreign tax credit.
That’s the easy part. The hard part of the foreign tax credit rules is in the multitude of limitations. The amount of foreign tax credit that can be claimed because of IRC §960 is limited in several ways.
And without getting into the details of why there are limitations and how they work, the upshot of the various limitations is that you, the tax professional, must track 10 different categories of earnings and profits for a CFC in order to comply with the foreign tax credit rules and calculate the allowable foreign tax credit.
Those 10 different categories are identified in Reg. §1.960-3(c). And – qu’elle surprise! – the earnings and profits columns on Schedules E-1, J, and P are all precisely matchy-matchy to the Regulation.
Schedule P, Column (h): “Section 951A PTEP”
“Section 951A PTEP” is the simpler of the two column descriptions. Let’s start there.
Here is the definition in the Regulation for the earnings and profits that go into column (h). Note how the definition matches the column title. That’s how you know that Reg. §1.960-3(c)(2)(viii) maps to Schedule P, column (h).
Reg. §1.960-3(c)(2)(viii) — Earnings and profits described in section 959(c)(2) by reason of section 951A(f)(2) (“section 951A PTEP”)[.]
IRC §959(c) defines three pools of CFC earnings and profits in IRC §959(c)(1), (2), and (3).
IRC §959(c)(2) is for previously-taxed earnings and profits. These earnings and profits might have arrived in the “previously-taxed” pool from a variety of sources, e.g., subpart F or global intangible low-taxed income. There are different types of earnings and profits within the IRC §959(c)(2) pool and they must be tracked separately in order to get the right results for distributions and foreign tax credits. Thus, we end up with several sub-pools of PTEP in the IRC §959(c)(2) pool.
I’m strenuously trying to Keep it Simple here. If you are a foreign tax credit genius, please forgive my breezy explanations and lack of precision.
Here’s the beginning of Anne’s answer. She has a CFC with global intangible low-taxed income in the current year. The earnings and profits go initially onto Schedule H. From there, the earnings and profits will go to Schedule J, column a, then get moved to column (e)(viii) – “section 951A PTEP.”
Finally, Schedule P (the shareholder’s share of accumulated earnings and profits maps the shareholder’s pro rata portion of the CFC’s earnings and profits in Schedule J, column (e)(viii) to Schedule P, column (h).
Column (d): “Reclassified section 951A PTEP”
This is the more complicated category of section 951A PTEP. There’s an adjective (“reclassified”) to contend with, and we all know what Stephen King says about adjectives. (“The road to hell is paved with adjectives.”)
We know what section 951A PTEP is. It’s just the CFC’s earnings and profit allocable to global intangible low-taxed income included in the gross income of a U.S. shareholder. It goes in Schedule P, column (h).
What does “reclassified” mean?
“Reclassified section 951A PTEP” comes from Reg. §1.960-3(c)(2)(iv):
Reg. §1.960-3(c)(2)(iv) – Earnings and profits described in section 959(c)(1)(A) that were initially described in section 959(c)(2) by reason of section 951A(f)(2) (“reclassified section 951A PTEP”)[.]
“Reclassified” is the only difference between the two. It means that previously-taxed earnings and profits were originally classified in the IRC §959(c)(2) pool of PTEP. Then, for some reason, the earnings and profits were taken out of the IRC §959(c)(2) pool of PTEP and placed in the IRC §959(c)(1) pool of PTEP.
Something happened to cause the PTEP to be taken out of one pool and placed in another. But what happened?
- The IRC §959(c)(2) pool is for PTEP from subpart F income or IRC §951A inclusions.
- The IRC §959(c)(1) pool is for PTEP from a CFC’s investment in U.S. assets (IRC §956 causes inclusion of E & P in the shareholder’s gross income in that event).
Thus – and again let’s not get caught up in the details – in order for section 951A previously taxed earnings and profits to be reallocated from the IRC §959(c)(2) pool to the IRC §959(c)(1) pool, the CFC must have made an investment in U.S. assets.
This investment wouldn’t cause a second inclusion of income for the shareholder under IRC §956 – because the earnings and profits have already been included in the gross income of the U.S. shareholder under IRC §951A.
But it would cause the earnings and profits to be reclassified from one pool to another, because the foreign tax credit rules and the distribution of earnings and profits to shareholders (and the tax treatment of that distribution) follow strict ordering rules, and it’s important for those rules to pull the E & P out of the right pool, in the right sequence.
So there you have it, Anne!
- Schedule P, Column (d) is for earnings and profits included in a shareholder’s gross income because of IRC §951A (Global Intangible Low-Taxed Income) and the CFC invested those earnings and profits in U.S. assets (IRC §956).
- Schedule P, Column (h) is for regular E & P from IRC §951A — Global Intangible Low-Taxed Income.