US foreign tax credits: recent legislative developments



FW moderates a discussion about US foreign tax credits between Jim Alajbegu at EisnerAmper, Peter J. Connors at Orrick, Herrington & Sutcliffe LLP and Raymond Montero at True Partners Consulting LLC. 

FW: What are the various foreign tax credits available to offset US tax on income?

Montero: A US corporation can take a foreign tax credit (FTC) for both ‘direct’ and ‘indirect’ foreign income taxes paid. The direct FTC relates to foreign taxes the US company is directly responsible for, for example, conducting business in a foreign jurisdiction through a branch, withholding taxes on dividends or interest received by the US corporation. The indirect FTC applies where the US corporation owns at least 10 percent of the voting shares of a foreign corporation. In this case, when the US corporation either receives a dividend from the foreign corporation, or currently recognises income earned by the foreign corporation due to certain anti-deferral rules such as supbart F, the US corporation is allowed a FTC for its pro rata share of the foreign taxes paid by such foreign corporation. The indirect FTC applies to foreign taxes paid by foreign corporations which are at least at the sixth tier.

Alajbegu: US citizens and residents, and US corporations, generally are subject to federal income tax on their worldwide income, regardless of its source. The foreign tax credit regime is meant to mitigate the double taxation that would result if a US person’s foreign-source income were taxed both by the source country and by the US. In effect, by granting a foreign tax credit, the US cedes primary taxing jurisdiction over such income to the source country. There are two types of credits available to offset US tax on income. The first is the direct or foreign tax credit, under Internal Revenue Code (IRC) section 901. The classic FTC paradigm involves the direct derivation of income from overseas sources by a US taxpayer and the imposition of an income tax, or similar tax, by a foreign country on that income. The second type of FTC is the indirect or deemed paid credit under section 902. Section 902 applies the general FTC rule of section 901 to instances in which the foreign tax is actually paid by a foreign corporation in which the US taxpayer – which must be a corporation – is a 10 percent or greater shareholder.

Connors: The foreign tax credit is the main mechanism in the US tax system to eliminate double taxation on foreign source income. In its current form, the limitation applies separately to passive income and to all other income. The starting point is the determination of foreign source income in the respective category. In determining foreign source income, expenses of a US taxpayer must be allocated and apportioned. There are two types of credits which are available: the direct credit and the indirect credit. The indirect credit is not available to individuals. The indirect credit is available for a domestic corporation that receives a dividend or deemed distribution – pursuant the anti-deferral rules of subpart F which are applicable to controlled foreign corporations – from certain foreign subsidiaries of which it has 10 percent  or more voting control. Both types of credits are available to the person upon whom foreign law imposes the tax. This is referred to as the ‘technical taxpayer rule’. Treaties also address double taxation. Tax treaties generally enhance a US taxpayer’s ability to claim a foreign tax credit on income as to which foreign tax country has been allocated jurisdiction.

FW: Can you outline in broad terms the recent changes to US international tax rules which limit US companies’ allowable foreign tax credit?

Alajbegu: IRC section 901 and 902 and Treasury Regulations thereunder are intended to implement the foreign tax credit regime. The intent is to reflect awareness that, because the Code differs significantly from the income tax laws of many foreign countries, there may be differences between a taxpayer’s taxable income as computed under US principles and as computed under the applicable foreign country’s laws. The Code and Treasury Regulations provide guidance as to how such differences are to be addressed when computing the foreign tax credit. The Education Jobs and Medicaid Assistance Act enacted section 909, which provides a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income. If there is a foreign tax credit-splitting event with respect to a foreign income tax paid or accrued by the taxpayer, the tax is not taken into account before the tax year in which the related income is taken into account for US tax purposes under Chapter 1 of the Code by the taxpayer.

Connors: There were four major changes. First, section 909 defers the foreign tax credit when there has been a splitting event. In general terms, this situation occurs when there is a difference between who is considered the taxpayer under US and foreign law. A ‘splitting’ event generally occurs if the related income is, or will, be taken into account by a person related to the taxpayer. In this case, the credit is not available until the related income is taxable for US tax purposes. Second, section 901(m) addresses the situation where a transaction is treated differently for US and foreign tax purposes, resulting in the measure of income subject to tax being different. In this case, the related foreign tax is disallowed as a credit, but may be taken as a deduction. A third change relates to differences arising from treaty double taxation treaties. Where income that is otherwise US sourced is resourced by reason of a double taxation as foreign source income, it becomes subject to a separate limitation and, thus, cannot increase the foreign tax credit limitation applicable to other classes of income. The final change relates to credits arising from deemed distributions from controlled foreign corporations under anti-deferral legislation. The legislation limits the amount of foreign tax credits available with respect to a deemed dividend under section 956 to the amount that would have been allowed to an actual dividend flowing up the chain of ownership.

Montero: While there were many changes made to the US international tax rules, there were three key areas. First, disallowing a FTC where foreign taxes have been split from the related foreign income. Second, minimising the high effective foreign tax rate caused by certain acquisition transactions which are treated as asset acquisitions for US purposes but share acquisitions for local country purposes. Finally, eliminating the selective ability to trigger either high taxed or low taxed pools of income by lending funds from such entities back to the US group rather than distributing such income to the US, which may involve distributing cash through various tiers of entities.

FW: What were the reasons behind this groundbreaking tax legislation?

Connors: There is a general belief that the US foreign tax credit system is too favourable to taxpayers and allows taxpayers to use more credits than is necessary to eliminate double taxation. For instance, the technical taxpayer rules allowed taxpayers to use credits without picking up any income for US tax purposes. The Obama administration believes that further changes are necessary. 

Montero: Although the legislation targets techniques the government believes were abusive, the breadth of the new rules goes beyond transactions which may be viewed as abusive, and encompasses many purely business transactions which were structured in ways currently sanctioned by the tax code. As Justice Learned Hand said, “Anyone may arrange his affairs so that his taxes shall be as low as possible…There is not even a patriotic duty to increase one’s taxes”. Accordingly, part of the new rules were motivated as much by the need to raise revenue as it was to close perceived tax loopholes. The legislation is aimed at preventing taxpayers from creating separate high taxed and low taxed income pools, and then selectively triggering either the high taxed or low taxed income to be recognised in the US, along with the related credits; or accelerating the availability of foreign tax credits without the corresponding income.

Alajbegu: There are three main reasons behind the new tax legislation. First, the abuse of foreign tax credit elections. Second, the improper deferral of income through inconsistent, and misapplication of, foreign country tax rules and US credit system. The third reason is to mitigate certain transactions that currently abuse international tax principles and evade US taxation, not just double taxation. 

FW: In what way does the new legislation restrict foreign tax splitters under section 909?

Montero: Foreign income tax ‘splitter’ transactions essentially try to separate the foreign income taxes from the foreign income to which such taxes relate, thus providing an opportunity to repatriate either high-taxed or low-taxed income, depending on the taxpayer’s FTC position. This segregation of the underlying foreign income taxes from the related income can be achieved either through certain hybrid instruments or hybrid entities – instruments or entities treated one way for US purposes but another way for local law purposes. Section 909 restricts taxpayers from benefitting from such transactions by deferring the creditability, or deductibility, of such foreign taxes until the related income is recognised for US income tax purposes.

Connors: If there is a splitting transaction, the foreign taxes will not be available until the related income is taxable. For example, assume a taxpayer operates in the UK through a Scottish law partnership that is treated as a corporation for US tax purposes. Under UK law, the partners in the partnership would be liable for the tax. Under US law, assuming the anti-deferral rules did not apply, no income would be taxable in the US until a distribution is made. Under the legislation, a credit for the UK taxes would not be available until the related income was taxable.

Alajbegu: In general, under section 909, a ‘foreign tax credit splitting event’ occurs when a person that is related to the payor of a foreign income tax takes into account, under US federal income tax principles, the income related to such tax. If there is a splitting event, then the person paying the applicable foreign income tax cannot take such tax into account for purposes of section 902 or 960 until that person has taken into account the income on which the tax is imposed. If there is a foreign tax credit-splitting event with respect to a foreign income tax paid or accrued by a 902 corporation, the tax is not taken into account for purposes of the deemed-paid credit under section 902 or 960, or for purposes of determining earnings and profits (E&P) under section 964(a), before the tax year in which the related income is taken into account for US tax purposes by the 902 corporation or a domestic corporation that meets the ownership requirements of section 902(a) or section 902(b) with regard to the section 902 corporation. Section 909(d)(5) defines a section 902 corporation as any foreign corporation with regard to which one or more domestic corporations meet the ownership requirements of section 902(a) or 902(b). Section 909 generally is effective with respect to foreign income taxes paid or accrued by US taxpayers and section 902 corporations in tax years beginning after 31 December 2010.

FW: Can you explain how section 901(m) will impact covered asset acquisitions?

Alajbegu: A covered asset acquisition (CAA) is defined in section 901(m) to include, first, qualified stock purchase to which section 338(a) applies, second, any transaction which is treated as an acquisition of assets for US tax purposes but is either treated as an acquisition of stock or disregarded for purposes of foreign income taxes of the relevant jurisdiction, third, any acquisition of an interest in a partnership which has a section 754 election in effect, and finally, any ‘similar transaction’, as specified by the Secretary of the Treasury. Congress apparently intended section 901(m) to prevent taxpayers from exploiting certain transactions that give rise to a permanent difference between the taxpayers’ US taxable base and foreign taxable base, in a manner inconsistent with the basic purposes of the foreign tax credit system. The legislation that enacted section 901(m) was introduced in the spring of 2010, as an amendment to a bill that extended expiring tax benefits.

Montero: ‘Covered asset acquisitions’ are acquisition transactions which are treated as share acquisitions for local law purposes, but asset acquisitions for US income tax purposes – for example, a US corporation acquires shares of a foreign corporation and makes a section 338(g) election to treat the acquisition as an asset acquisition for US tax purposes. In such a case, post-acquisition income for US tax purposes will generally be lower than the corresponding income for local country tax purposes, because of the greater depreciation/amortisation deductions resulting from the stepped up US tax basis of the target’s assets. This difference will generally give rise to a very high effective foreign tax rate for US FTC purposes. Section 901(m) reduces the amount of foreign tax available for credit in each year, in the same ratio as the basis difference allocable to such year compares to the income on which the foreign taxes are determined for such year.

Connors: An example of a covered asset acquisition is where a US corporation acquires a foreign corporation from a third party and, as part of the transaction; the target makes a section 338(g) election. As part of the election, for US tax purposes, the asset bases are stepped up to fair market value for US tax purposes. They are not stepped up for foreign tax purposes. Thus, deductions are available for US tax purposes for items such as depreciation and the amortisation of goodwill. As a result, when foreign tax credits are calculated, the amount of credit that is available is disproportionately higher than the amount of income tax that would be applicable using US tax principles on the income . The legislation would disallow the credit to the extent it is greater than the amount determined based on foreign income principles.

FW: How do the new rules relating to section 956 affect foreign tax credits on the income recognised as a result of investments in US property made by a controlled foreign corporation (CFC)? Do the new rules essentially put the taxpayer on a global, pooled basis for foreign tax credits?

Connors: The rules require that the calculation of the dividend be made as if the taxes had been paid as a dividend, rather than directly from the subsidiary making the investment in US property. Thus, the high tax rate that is otherwise applicable at the subsidiary level may be reduced. The change is a form of ‘pooling’ in that tax credits are not considered merely on the basis of the company making the distribution or investment in US property.

Alajbegu: A section 951(a)(1)(B) or subpart F inclusion is generally the income inclusion of a US shareholder of a CFC arising from the CFC’s investment in US property. Under current law, a US company’s deemed-paid taxes attributable to a subpart F inclusion from a lower-tier CFC comes from the CFC to the US company without interfering with the earnings and taxes of upper-tier CFCs. This is often referred to as the section 956 ‘hopscotch’. The new law adopts a provision to stop the section 956 hopscotch by limiting the amount of foreign taxes deemed paid with respect to tax code section 956 inclusions (the hopscotch rule), effective in 2011. Under the new law, section 960 is modified to provide a new rule for determining the deemed-paid foreign income tax associated with a section 951(a)(1)(B) inclusion. For acquisitions of US property after 31 December 2010, the new law prevents taxpayers from maximising their foreign tax credits by selectively repatriating income from high-taxed foreign subsidiaries while continuing to defer US tax on income of low-taxed foreign subsidiaries.

Montero: Section 956, an anti-deferral provision, isn’t generally desirable. However, prior to the new rules, where a US corporation had subsidiaries with high taxed income and subsidiaries with low taxed income, section 956 provided the ability to selectively include high taxed or low taxed income by, for example, loans from such subsidiary to the US parent. The new legislation eliminates this opportunity by requiring the US corporation to compute its FTC on a section 956 income inclusion by using the lower of two FTC computations: first, treating income as distributed directly to the US corporation, or second, treating income as deemed distributed up the chain. While limiting the selective inclusion of high taxed or low taxed foreign source income, the new rules do not put the taxpayer on a global, pooled basis for FTC purposes. Accordingly, proper FTC planning is still available within the context of an international group.

FW: Are there any other notable tax changes that have been introduced through this legislation?

Connors: There are also changes in the rules related to redemptions of foreign subsidiaries and the allocation of interest expense. The change in the redemption provisions is aimed at closing a loophole that permitted taxpayers to unwind certain CFC structures without US tax. In its 2011 and 2012 budget proposals, the Obama administration has proposed that a US taxpayer be required to determine its deemed paid foreign tax credit on a consolidated basis based on the aggregate foreign taxes and earnings, and profits of all of the foreign subsidiaries, with respect to which the US taxpayer can claim a deemed paid foreign tax credit – including certain lower tier subsidiaries. The deemed paid foreign tax credit for a taxable year would be determined based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the US taxpayer in that taxable year. This may well be part of the legislative agenda in 2011.

Montero: The provisions in the new law relating to splitter transactions, covered asset acquisitions and section 956 transactions are likely to have the broadest impact. There are some additional provisions worth noting, as follows. The new law creates a separate FTC limitation basket for income resourced as foreign source income pursuant to a treaty. It treats a foreign corporation as a member of an affiliated group for interest allocation purposes if it meets certain effectively connected income and ownership thresholds. It also prevents tax free repatriation of earnings to a foreign parent by limiting the amount of earnings and profits taken into considerations when determining dividend characterisation.

Alajbegu: This legislation also introduced new rules that limit the FTC on treaty resourced items, trigger deemed dividends on certain redemptions, modify the affiliation rules for purposes of allocating interest expense, repeal the 80/20 company rules which had provided foreign sourcing of interest and dividends paid by 80/20 companies, and provide a sourcing rule on guarantee fees.

FW: In your opinion, what will be the long-term impact of these changes? Do the new rules only affect the amount of credit otherwise available?

Montero: The impact of these rules will be much broader than originally anticipated by Congress, will add another level of complexity to an already too complex area of tax legislation, and may have unintended consequences. For example, currently, for sound policy reasons, a taxpayer that generates income which would otherwise be supbart F income can elect to have such income not be currently recognised to the extent it is considered to be ‘high taxed’. By deferring, or disallowing, the recognition of foreign taxes under the new legislation, this could have the effect of converting otherwise ‘high taxed’ income into supbart F income not eligible for the high-tax exception, such that the US corporation is now required to recognise income it otherwise would not be required to. 

Alajbegu: The long term impact of these changes will be more deferral type activities by companies to leave E&P offshore. The US should provide taxpayers with incentives for repatriation, rather than reducing their foreign tax credits. These new rules will continue to add to the complexity of the US tax system and encourage different types of tax planning.

Connors: These changes will significantly reduce available foreign tax credits. This is likely to increase the cost of making repatriations from foreign subsidiaries that are located in low tax jurisdictions. While the rules are directed at the foreign tax credit calculation, they will impact the structuring and form of certain acquisitions.

FW: How should companies respond to this new legislation in terms of tax planning?

Alajbegu: Taxpayers should re-examine their foreign tax credit positions. If taxpayers have foreign tax credit splitter structures, they should immediately begin to calculate their E&P pools and tax pools that are affected by the new legislation. Additionally, taxpayers with structures that planned for an inclusion under section 956 (investment of earnings in US property) from lower-tier controlled foreign corporations that anticipated not paying significant residual US tax, should assess how the enactment of the Education Jobs and Medicaid Assistance Act affects their tax positions.

Connors: This will be a company specific determination. Taxpayers with expensive, complex structures that are designed to take advantage of low and high tax rates may wish to consider revisiting these structures. However, the exact scope of the legislation will not be determined until regulations are issued – for example, in the case of the splitting event and covered asset legislation. Taxpayers are still likely to make section 338(g) elections even though the legislation has reduced some of the benefits of the elections. Taxpayers may wish to consider implementing changes that are not directly within the scope of the legislation as it will take time for the IRS and Treasury to articulate the scope of the applicable provisions.

Montero: US corporations need to address the impact of this new legislation by reviewing their existing international structure to determine whether changes need to be made to maximise the ability to best use high taxed or low taxed foreign source income. They should determine whether existing structures can be simplified, thereby minimising legal or local law costs or tax risks, since the benefits previously obtained from such structures have been reduced or eliminated under the new legislation. Finally, they should focus on the reduction of local country income taxes through appropriate tax planning, thereby reducing the impact of the new legislation which reduces the creditability of such taxes in the US.


Jim Alajbegu is a partner in the International Tax Services Group at EisnerAmper. His experience includes over 20 years of experience in both public and private accounting.  He has been responsible for myriad assignments in the multinational tax and transfer pricing areas including foreign tax credit studies and expense allocation reviews, earnings and profits studies, acquisitions and dispositions of operating units, corporate-wide reorganisations, representation in tax audits, tax accounting issues, and related other tax matters. Mr Alajbegu currently serves as chair of the NJSCPA’s International Tax Committee. He can be contacted on +1 (732) 947 3641 or by email: 

Raymond Montero is a managing director at True Partners Consulting LLC. He has over 29 years of experience in corporate and international tax consulting, having practiced in the US, the UK and Mexico. Mr Montero has a variety of clients and his focus of practice includes cross-border structuring, transfer pricing related matters, outbound international planning and consultation relating to foreign tax credit, CFC and PFIC. He can be contacted on +1 (818) 594 4915 or by email:    

Peter J. Connors is a partner at Orrick, Herrington & Sutcliffe LLP. He focuses his practice on cross-border transactions and has extensive experience in related areas of tax law, including financial transactions, corporate reorganisations, project finance, private equity investments as well as tax controversy. Mr Connors is the immediate past vice chair, committee operations, of the American Bar Association Tax section, a member of the Executive Committee of the New York State Bar Tax section and the New York Region vice president of IFA. He can be contacted on +1 (212) 506 5120 or by email:

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Jim Alajbegu



Peter J. Connors

Orrick, Herrington & Sutcliffe LLP


Raymond Montero

True Partners Consulting LLC

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