In the last post, we start talking about Foreign Tax Credits. In this post, we will talk about how they need to be broken down into their different basket categories before they can be applied against US income tax to avoid double taxation.
Foreign Tax Credits (FTCs) in Real Life
We recently started exploring the foreign tax credit and how it can be used to avoid double taxation when the USA taxes foreign income that has already been taxed by another country. This happens with some frequency to US taxpayers because:
- The US taxes its residents on their worldwide income, and worldwide income includes by definition foreign income that foreign countries where the income is from will tax.
- The US taxes its citizens and permanent legal residents as US tax residents, even when they live abroad where they are earning foreign income that is taxed by their country of physical residence.
The foreign tax credit, in theory, works like this:
You earn $100 in a foreign country. You pay $25 in income tax to the foreign country. The USA, because of the bullet points above, also taxes this foreign income. Let’s say that the US tax is also $25. You offset the $25 in US tax with the $25 of tax paid to the foreign country.
Magically, this foreign tax credit makes your US tax disappear.
You pay nothing to the USA. Double taxation is avoided. All is good.
That’s the theory.
But, as Albert Einstein pointed out: In theory, theory and practice are the same. In practice, they are not!
In practice, it’s a bit more complicated than our example.
There are many reasons why it is more complicated.
For starters, there are sourcing rules that limit the applicability of the foreign tax credit. There are also rules about what constitutes a creditable foreign tax and what doesn’t. Not every tax can be credited, it must be a foreign income tax. Foreign wealth taxes, which are usually calculated in foreign income tax returns, are one example of a foreign tax that cannot be taken as a credit to offset US income tax.
But the main reason it’s complicated is what it’s referred to as Foreign Income Baskets.
Foreign Tax Credit Category Baskets
What is a foreign income basket?
A foreign income basket is simply another word for foreign income category. The Internal Revenue Code classifies income into different categories and calls these categories, baskets.
What category baskets are there?
Let me show you.
You can find the different foreign tax credit baskets at the top of Form 1116, which is the form used by individuals to calculate their foreign tax credits (FTCs):
As you can see, there are seven different foreign tax credit baskets. They are the following:
- Section 951A basket
- Foreign Branch basket
- Passive basket
- General basket
- Section 901(j) basket
- Certain Income Resourced by treaty basket, and
- Lump-sum distributions basket
Let’s explore what each one of these baskets means:
Section 951 basket:
This basket made its debut at the end of 2017 when the Tax Cuts and Jobs Act (TCJA) was signed into law. Section 951 is a new section of the Internal Revenue Code (IRC) known as Global Intangible Low Taxed Income or GILTI. Our Congressmen were feeling very cheeky that month…..
GILTI is one of the most complex provisions of the IRC, so I’m not going to get into it. It would require a book, and a long one at that, to go over the implications of this new provision.
For purposes of this newsletter, this category rarely impacts our readers, so beyond being aware that it exists and that you may need to understand it if you operate a foreign business, let’s not worry too much about it.
You have my permission to be upset about it, though. It’s an onerous and burdensome basket.
Foreign Branch Basket:
This FTC basket is another TCJA of 2017 gift. Unfortunately, as opposed to the GILTI basket, this basket impacts Americans living overseas who work independently.
How so? You are going to love this!
When an American works independently, they are considered self-employed. Self-employed means, as the term implies, being an employee of oneself. When an American is self-employed abroad, they are a foreign employee of themselves. Since they are American, they are a US employer. Since they live abroad, they are also a foreign located employee. This combination of US employer with a foreign situs employee creates a “foreign branch” of the US expat in their country of residency.
Are you thinking that this is ridiculous? I hear you…..
Congress begs to differ though. They think this new FTC basket makes total sense.
Before 2018, self-employed income earned overseas fell into the General Limitation basket. From 2018 on, it’s Foreign Branch basket. This is NOT a good change because adding FTC baskets makes it more difficult to efficiently use FTCs to offset US income tax.
Passive income is one of the traditional income baskets that pre-exists the TCJA of 2017. In general, passive income is income derived from passive investments: interest, dividends, royalties and rents. For an individual taxpayer examples include the interest paid on savings accounts, dividends earned in investment accounts, royalties received from acquired intellectual property rights (royalties from self-developed are General Limitation) and rental income reported on Schedule E.
Section 901(j) basket:
This basket applies to income from countries with which the USA has severed diplomatic relations, it doesn’t recognize, or has sanctioned in some way. Examples include Iran, North Korea, Syria and Cuba.
I don’t expect any of our readers to have income from these countries, but if you do, understand that any tax paid to those countries is not eligible for the FTC. Such a tax is segregated for the purpose of denying the credit in this separate basket.
If you do have income from these countries, you should be aware that in addition to missing on the FTC, you may also get a visit from the Department of State…..
Certain Income Resourced by Treaty:
This is a category of potential great importance for our readers, if you are US expats and live in countries with which the USA has an income tax treaty.
If you are one of them, read up:
As we explained earlier, the US taxes its citizens and long term permanent residents (green card holders) on their worldwide income. It taxes them on their worldwide income even when they live overseas. Most countries also tax their residents on their worldwide income. The USA is not unique in this regard.
When you have a US expat living in a country that also taxes them on their worldwide income, you have two countries taxing the same person on their worldwide income and potentially leading to double taxation.
Let’s assume that a US expat owned their home before moving overseas. Unsure if they would want to return to their US home, the US expat converts it into a rental property and rents it during their expat assignment. This rental activity generates rental income. This rental income is US source income because the rental property is located in the USA.
Clear so far, right?
The USA will tax this rental income because it is US source income and because the beneficial owner is a US citizen.
Now let’s assume that this US expat lives in a country that taxes them on their worldwide income too. The US rental activity is also taxed by the foreign country. The rental income is double taxed.
Can this taxpayer use the foreign tax credit to offset the tax on the US side?
The short answer is NO.
Foreign tax credits can only be used to offset tax on foreign source income. Income from a US rental property is NOT foreign source income. It is US income taxed by a foreign country. Those are two very different things.
If the foreign country doesn’t have their own foreign tax credit rule, the rental income will be double taxed and the US expat will be SOL…..unless….
A tax treaty comes to the rescue. How does a tax treaty solve this double taxation problem?
By allowing the US expat to pretend that the US rental income is earned in the foreign country where they live. It is deemed to be “foreign” source income, even though it is US source income.
The tax treaty provision magically converts (resources) US source income into foreign source, thus allowing the use of foreign tax credits to offset the US income tax imposed on it.
Curious about the most common situation in which US expats use this treaty benefit?
The answer is: interest and dividend income from US financial accounts and investments.
It is very common for foreign countries to tax US US dividends and interest if the beneficial owner lives in that country. If the tax treaty didn’t allow the US expat to pretend that the interest and dividends are foreign, the US expat would end up paying tax twice.
Lump-sum distribution basket:
A lump-sum distribution takes place when a large amount of money is distributed all at once, instead of being broken down into installments or smaller size payments. Lump-sum distributions are common with pension fund or retirement account distributions, when the entire account is distributed at once.
This FTC basket allowed for preferential treatment of lump-sum distribution income until the tax reform of 1986. Now, it is only available to taxpayers who were born before 1936 and who are participants in foreign retirement plans eligible for this special 20% lump-sum distribution rate on contributions made before 1974.
Many of you were not even born before 1974……
Finally, we have arrived at the best FTC basket:
General limitation basket:
Why is this the best basket? Because it’s the catch-all basket.
Any income that does not fit into another category previously described, is General Limitation income.
Want some examples of general limitation income?
- Retirement account distributions
- Social security income
- Taxable employee benefits (paid in cash or in kind)
- Hobby income
- Gambling income
If you work abroad for a foreign employer, the greater part of your foreign income will fall under the General Limitation basket.
If you live in the USA, your foreign income is most likely to be investment income, and thus fall under the Passive basket (interest, dividends, royalties, rents, capital gains, etc.)
Once I know my baskets, then what?
The fun begins!
But we will have to wait until the next issue of CBP for the fun part.
In it, we will discuss how to allocate your foreign income tax to the different baskets, and how to use this basket allocation to calculate and apply your foreign tax credits.
See you in our next issue to find out!
Un abrazo y buena onda,