Distinctions Between State and Federal Taxation of Foreign Source Income

Distinctions Between State and Federal Taxation of Foreign Source Income

By Suellen M. Wolfe, LL.M., CPA

The federal Internal Revenue Code provides that foreign corporations are subject to U.S. income tax on certain foreign source income that is "effectively connected" with a U.S. trade or business. Jurisdiction to subject the foreign corporation to U.S. income tax is premised on the derivation of income that is sourced to the United States. The sourcing rules are the first step in determining whether the gross amount of "fixed or determinable annual or periodical income" paid to foreign persons is subject to U.S. Income Tax and are the initial measure to calculate income considered "effectively connected" with the conduct of a trade or business within the U.S.

For U.S. corporations with subsidiaries incorporated outside the United States, the subsidiaries' repatriated earnings are typically taxed through a dividend distribution. The U.S corporation's domestic and foreign taxable earnings may also include interest, royalties or service charges received by the U.S. parent from its foreign affiliates.

A federal tax credit is allowed for foreign source income or withholding taxes imposed on foreign income. The credit assists in reducing the effect of double taxation on the U.S. income tax and any foreign income taxes imposed on the income earned from sources outside the U.S.

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Although state tax treatment follows federal tax treatment in many areas, states modify that treatment in major areas.

Because most state tax bases begin with federal taxable income, corporate income tax statutes do not provide for a credit for foreign income taxes. There are, however, certain modifications that are made by many states. A typical state modification excludes the federal foreign tax credit "gross-up" amount from the state tax base, either by extending the dividend-received-deduction to include the 
IRC § 78 credit amount or by providing for a subtraction of the credit amount...

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A few courts have held that a U.S. corporation's election of an IRC § 78 credit does not preclude the taxpayer from taking a deduction for those taxes in the computation of the state income tax. In Amerada Hess Corp. v. State ex rel. Fong, 2005 ND 155 (N.D. 2005), the court held that a corporation's federal "gross-up" amounts did not constitute "foreign dividends," and thus were not eligible for a partial exclusion from state taxable income. The unitary group was required to include in its income dividends received from an "80/20 corporation" even though the subsidiary's income from which the dividends were paid was also included in the group's income.

Another area in which state tax law may differ from federal law is in the dividends received deduction (DRD)...

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Most states provide some form of DRD for dividends derived from foreign sources. However, the definition of a dividend varies from state to state. In many states, IRC Subpart F income and income derived from investments in U.S. property is treated as dividend income. Accordingly, it is eligible for the DRD in many jurisdictions. IRC 1248 income, typically characterized as capital gain rather than dividend income, is treated as dividend income under IRC § 1248(a). Therefore, it is eligible for a state DRD.

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