Tax Law

The Changing Landscape of the Foreign Tax Credit Regime



            The tax landscape is changing for the amount U.S. multinational corporations may claim through the foreign tax credit.  This change is the result of the Statutory Pay-As-You-Go Act of 2010 that requires any increased spending must be offset by a corresponding increase in revenue.[1]  The foreign tax credit modifications narrowly escaped becoming the offsetting revenue raising provisions of the Unemployment Compensation Extension Act of 2010 that extended unemployment benefits.[2]   However, the success was short-lived, as these modifications were added to Pub. L. No. 111-226. This legislation provides $10 billion of elementary and secondary education funding to protect teacher jobs from being cut.[3]  Nearly $10 billion over ten years is expected to be raised by altering various rules that corporations leverage to calculate their foreign tax credits and foreign-source income, providing the necessary revenue offset for this law.  

Here, we will examine the concept behind foreign tax credits offered in the United States; the history of foreign tax credits in the United States; the changes to the foreign tax credits; and the public policy behind the bill and the potential effects upon multinational corporations.


I. The Concept of Foreign Tax Credits


            Income tax systems that tax residents on worldwide income generally offer a foreign tax credit to mitigate the potential for double taxation.  The United States employs a global tax system and taxes the income earned abroad, known as foreign source income, by its residents under the residence principle.[4]  Generally, foreign source income is also subjected to tax in the foreign country.  As a result, the United States offers a tax credit for any foreign income taxes paid in an attempt to avoid double taxation on the foreign source income. 

The taxpayer is allowed to subtract the foreign income tax from the tentative U.S. income tax due on the foreign source income and is required to pay only the difference to the United States.  However, the credit is limited to the tentative U.S. tax, meaning no refund is available if the foreign income tax exceeds the tentative U.S. tax on the foreign source income.  For foreign taxes other than income tax, deductions are allowed against the foreign taxable income instead of being credited against the U.S. tax.

            U.S. corporations usually earn foreign source income by operating branches abroad or either by operating via an affiliate or investing in subsidiaries incorporated abroad.  The foreign tax credit offers different advantages depending upon the form of the entity abroad.  If a branch of a U.S. corporation is subject to foreign income taxes a credit is given for the foreign income taxes when the branch remits the income annually to its U.S. parent.  This differs from the tax consequences of operating via either an affiliate or a subsidiary abroad as opposed to a branch.  For foreign source income earned by an affiliate that is a separate company incorporated abroad and the U.S. parent owns at least 10 percent of the affiliate, then U.S. tax only attaches when the income is remitted in the form of dividends to the U.S. parent.  These unremitted earnings defer the attraction of U.S. tax until the earnings are repatriated.  But for the application of subpart F controlled foreign corporation rules, the deferral may be indefinite.

            In general, a U.S. parent corporation may aggregate their foreign source income and foreign taxes paid from all of its foreign operations.  However, to be lumped together the foreign source income must be within the same category of income, or "basket", as defined by the Internal Revenue Code.  The American Jobs Creation Act of 2004 reduced the number of income baskets from eight to just two for tax years beginning in 2007.  These two remaining income baskets are passive income and general income.[5]  These two separate baskets exist to discourage U.S. corporations from moving offshore highly mobile passive investments that can be located in low-tax jurisdictions in order to increase their tentative U.S. tax by increasing their foreign source income.  The increased U.S. tentative tax will allow the offset of previously forgone foreign tax credits for non-passive operations in high tax jurisdictions.


II. History of Foreign Tax Credits in the United States


            When Congress created the first income tax, it addressed the issue of foreign double taxation by allowing taxpayers to deduct their foreign taxes when computing their taxable income.[6]  In 1918, after the cost of World War I drove up the rates of both domestic and foreign taxes, Congress passed the foreign tax credit provisions to provide greater relief in cases of double taxation.  These provisions allowed for taxpayers to choose between deducting their foreign taxes from taxable incomes or taking a dollar for dollar credit against their U.S. tax liabilities.  After the Technical Amendments Act of 1958, taxpayers could carry their unused foreign taxes forward five years or back two.

            The foreign tax credits provisions allow taxpayers an indirect credit for foreign taxes "deemed paid" by the underlying subsidiary of a taxpayer's subsidiary.  To be eligible for the indirect credit, the U.S. parent must own a minimum percentage of the foreign subsidiaries stock.  In 1962, the ownershippercentage was lowered from the original 50 percent to the current level of 10 percent.  Also, until 1976, taxpayers could claim the credit for a second-tier subsidiary at least 50 percent owned by the first tier.  The Tax Reform Act of 1976 expanded the level of ownership to three tiers with just 10 percent ownership for all tiers, provided that combined ownership of all tiers is at least 5 percent.  Congress further expanded the indirect credit through to a sixth underlying tier of the U.S. parent, while maintaining the 5 percent cumulative ownership rule for each tier.[7] 

            Congress has also created various limitations and reductions throughout the life of the foreign tax credit provisions.  Initially, companies were allowed an unlimited amount of foreign tax credit.  To remedy a potential U.S. subsidy to foreign jurisdictions with higher tax rates, Congress added in 1921 a limitation that capped creditable foreign taxes to the U.S. prevailing rate.  Congress established the limitation of the amount of foreign tax credit available to a corporation's U.S. tax liability multiplied by a ratio of foreign source-income to worldwide income.   Further limitations included an overall foreign loss recapture added in 1976 with the intent to limit the amount of domestic tax liability that could be offset by foreign losses.

            The American Jobs Creation Act of 2004 revised the foreign tax credit provisions further.  The law adjusted how taxpayers calculate the credit for the purpose of the alternative minimum tax.  Also, the revisions modified rules that govern how companies allocate interest expenses away from foreign source income to increase their available tax credit.  The carryback period was also reduced to one year, while the carryforward period was increased to ten years.[8]  Lastly, an overall domestic loss recapture was added to compliment the already existent foreign loss recapture.[9]


III. The Changes Enacted by Pub. L. No. 111-226


            The Education Jobs and Medicaid Assistance Act of 2010 (Pub. L. No. 111-226) includes a package of provisions developed jointly by the Treasury Department, the Committee on Ways and Means and the Senate Finance Committee to prevent alleged mismatches and abuses of the U.S. foreign tax credit system.  Primarily, Treasury alleges that taxpayers have developed methods to utilize their foreign tax credits to reduce their U.S. tax without correspondingly incurring U.S. tax on that foreign income, thus obscuring the policy intent of the elimination of double taxation.[10] 


A.  Rules to Prevent Splitting Foreign Tax Credits from Income

            Taxpayers have devised several techniques for splitting foreign taxes from the foreign income on which those taxes were paid.  These techniques allow for the foreign income to remain offshore and untaxed by the United States, while the foreign taxes are currently available in the U.S. to offset U.S. tax that is due on other foreign source income.  Often, the foreign income is permanently reinvested offshore such that it likely will never be repatriated and taxed in U.S.  These techniques use foreign tax credits in a method that does not relieve double taxation burdens. 

            Pub. L. No. 111-226 adds Section 909 - "Suspension of Taxes and Credits Until Related Income Taken Into Account" - to the I.R.C. Foreign Tax Credit provisions.[11]  New Section 909 states:


(a) IN GENERAL.- If there is a foreign tax credit splitting event with respect to a foreign income tax paid or accrued by the taxpayer, such tax shall not be taken into account for purposes of this title before the taxable year in which the related income is taken into account under this chapter by the taxpayer.


Thus, Section 909 implements a matching rule that suspends the recognition of foreign tax credits until the related income is taken into account for U.S. tax purposes.  These rules will not affect timing differences that result from normal tax accounting differences between foreign and U.S. tax rules.[12]


B.  Denial of Foreign Tax Credit with Respect to Foreign Income not Subject to United States Taxation by Reason of Covered Asset Acquisitions

            Current rules allow taxpayers to treat a stock acquisition as an asset acquisition under U.S. tax law or obtaining interests in entities treated as corporations for foreign tax purposes but considered as non-corporate for U.S. tax law.  These acquisitions are referred to as "covered assets acquisitions".  These transactions result in a step-up in the basis of the assets of the acquired entity to the fair market value paid for the stock.  This step-up usually exists only for the U.S. tax purposes and not the foreign tax purposes.  As a result, depreciation for U.S. tax purposes exceeds the depreciation for foreign tax purposes, so that the U.S. taxable basis is lower than foreign taxable base.  Since foreign tax credits are based on the foreign taxable base, there are more foreign credits than necessary to avoid double taxation.  Taxpayers are then using these additional foreign tax credits to reduce taxes imposed on other, completely unrelated foreign income.  The bill prevents taxpayers from claiming the foreign tax credit with respect to foreign income that is never subject to U.S. taxation due to a covered asset acquisition.[13]


C. Separate Application of Foreign Tax Credit Limitation to Items Resourced Under Tax Treaties

            Taxpayers have devised a technique to use the U.S. treaty network to enhance foreign tax credit utilization by artificially inflating foreign source income.  To do this, ownership of income-producing assets that ordinarily would be held by the U.S. based multinational companies in the United States is shifted to foreign branches and disregarded entities.  This income is often lightly taxed on a net basis by the foreign country, but the treaty ultimately categorizes the entire gross amount of the income generated by U.S. assets as foreign source.  This results in the taxpayer's foreign source income to be artificially inflated and allows the taxpayer to use foreign tax credits to reduce taxes on foreign source income beyond the maximum amount of U.S. tax that could be imposed.  The bill respects the treaty commitment to treating the income as foreign source, but segregates the income so that it is not the basis for claiming foreign tax credits.[14]


D.  Limitation on the Use of Section 956 for Foreign Tax Credit Planning

            U.S. based multinational companies typically employ complex foreign structures designed to reduce worldwide tax expenses.  These structures often include companies located in low-tax jurisdictions in a multi-chain tier of subsidiaries.  If a foreign subsidiary with a high tax expense distributes a dividend through a chain of companies, the foreign tax credit on the dividend the U.S. multinational receives is a blend of tax rates.  If there were a tax haven company in that chain, the U.S. tax due on the dividend may be significantly higher than the tax would have been if the foreign subsidiary's dividend had "hopscotched " over the chain as a direct distribution.  Use of section 956 accomplishes this hopscotch by deeming a dividend from a foreign subsidiary directly to the U.S. shareholder.  By taking advantage of this rule the foreign tax credit on a "deemed dividend" can be greater than the foreign tax credit would be on an actual dividend.  The bill 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 following the chain.[15] 


E. Special Rule with Respect to Certain Redemptions by Foreign Subsidiaries

            Where a foreign-based multinational owns a U.S. company, and that U.S.-company owns a foreign subsidiary, the earnings of the foreign subsidiary are generally subject to U.S. when they are distributed to the U.S. shareholder.  Foreign-based multinational companies have devised a technique for avoiding U.S. taxation of such foreign subsidiary earnings.  This technique involves a provision of the tax code that was originally enacted as an anti-abuse rule that treats certain sales of stock between related parties as a dividend.  This deemed dividend allows the foreign subsidiary's earnings to completely, and permanently, bypass the U.S. tax system.  The bill eliminates this type of tax planning by preventing the foreign subsidiary's earnings from being reduced and, as a result, the earnings will remain subject to U.S. tax when repatriated to the foreign parent corporation as dividend.[16]


F.  Modification of Affiliation Rules for Purposes of Rules Allocating Interest Expense

            Taxpayers have used various techniques to minimize the amount of foreign source interest expense, which has the effect of artificially boosting foreign source income.  This allows the taxpayer to utilize more foreign tax credits than would otherwise be possible, and the use has no bearing on double taxation relief.  Treasury regulations prevent taxpayers from excluding foreign interest expense from the foreign tax credit limitation by placing it in foreign subsidiaries.  The regulations achieve this result by including certain subsidiaries in the U.S. affiliated group.  As a result, foreign source interest expense will be taken into account in the determination of the foreign tax credit limitation.  The bill modifies the affiliation rules to strengthen these anti-abuse rules.[17]


G. Repeal of 80/20 Rules

            Under current law, dividends and interest paid by a domestic corporation are generally considered U.S.-source income to the recipient and subject to gross basis withholding if paid to a foreign person.  If at least 80 percent of a corporation's gross income during a three year period is foreign source income and is attributable to the active conduct of a foreign trade or business, dividends and interest paid by the corporation will generally not be subject to gross basis withholding rules.  Additionally, interest received from an 80/20 company can increase the foreign source income of a U.S. multinational company.  Treasury has become aware that some companies have abused the 80/20 company rules.  The bill repeals the 80/20 company rules, repeals the 80/20 rules for interest paid be resident alien individuals, and includes relief for existing 80/20 companies that meet specific requirements and are not abusing 80/20 company rules.[18]


I.  Technical Correction to Statute of Limitations Provision in the HIRE Act

            The bill makes a technical correction to the foreign compliance provisions of the Hiring Incentives to Restore Employment (HIRE) Act (P.L. 111-147) that clarifies circumstances under which the statute of limitations will be tolled for corporations that fail to provide certain information on cross-border transactions or foreign assets.  Under the correction, the statute of limitations period will not be tolled if the failure to provide such information is shown to be due to reasonable cause and not willful neglect.[19]


IV. Public Policy and Potential Effects of the Bill[20]

            Any discussion of changes in tax policy, regardless of cutting or increasing tax revenues, always brings out intense passions.  Advocacy groups such as the Tax Policy Center, Citizens for Tax Justice, and the National Women's Law Center all support the closing of tax loopholes for U.S. multinational corporations.[21]  As expected just as many advocacy groups strongly oppose any effort to change the current tax landscape.  These groups include the U.S. Chamber of Commerce, the Heritage Foundation, the National Foreign Trade Council, the Business Roundtable, the National Association of Manufacturers, the Information Technology Industry Council and the Americans for Tax Reform.[22]

            The potential benefits of the tax changes include increasing domestic job opportunities.  According to proponents, job opportunities will increase domestically as a result of ending the preferential treatment that give an incentive to U.S. multinationals to move more of their business abroad by providing subsidies.[23]  Also, by limiting the deficit burden of the extension of jobless benefits, the tax policy changes may protect national saving and spurn economic growth.[24]  More importantly, a study done by Moody's found that extending unemployment benefits had one of the highest impacts on economic growth at $1.61 in growth for every dollar spent while a permanent cut to the corporate tax rate would yield $0.32 in growth per dollar.[25]

            The potential negative effects of the tax changes include hindering job creation, decreasing overseas competitiveness of American business, and deterring economic growth.[26]  Further, an increased tax burden may encourage U.S. firms to sell their foreign subsidiaries to foreign-based firms.[27]  Other critics argue that the revenue sought to be raised will be elusive, either because the tax hikes will harm U.S. exports and jobs or because worldwide American companies will merely shift their organizational structure to avoid the tax.[28]  Also, critics argue that the limitation on the Section 956 loans will deny sources of cash to worldwide American companies and jeopardize the fragile recovery achieved thus far.[29]  Additionally, some advocates believe that the tax hike will actually drive more jobs overseas instead of create jobs in America.[30]  Lastly, critics state that at a time when America needs to be taking steps to promote competitiveness, the tax hikes send an opposite message to would-be investors.[31]

            Regardless of which side of the debate one falls, data does exist to show that as multinational corporations increase employment abroad that they increase employment domestically as well.[32]  However, a weak connection exists between job creation or losses and tax policy, according to some tax experts.[33]  To further complicate the debate, both the United Kingdom and Japan have altered their tax policies away from a worldwide source system, leaving the United States alone in their international tax policies.[34]   


[1] Statutory Pay-As-You-Go Act of 2010, 2 U.S.C. § 933(g) (2010).

[2] Unemployment Compensation Extension Act of 2010, Pub. L. No. 111-205, 124 Stat. 2236 (2010).

[3] _____ Act of ____, Pub. L. No. 111-226, 124 Stat. 2389 (2010).

[4] Donald J. Rousslang, Foreign Tax Credit, in The Encyclopedia of Taxation and Tax Policy, 163 (Joseph J. Cordes, Robert D. Ebel, & Jane G. Gravelle eds., 2d ed. 2005), available at

[5] I.R.C. §904(d)(1).

[6] Melissa Redmiles & Jason Wenrich, A History of Controlled Foreign Corporations and the Foreign Tax Credit, Internal Revenue Service, 129 (2007),

[7] Id. at 130.

[8] I.R.C. §904(c).

[9] Id. at 131.

[10] Staff of S. Comm. on Finance, 111th Cong., Summary of Changes Made by Senate Substitute Amendment to American Jobs and Closing Loopholes Act 18 (Comm. Print 2010).

[11] _____ Act of ____, Pub. L. No. 111-226, 124 Stat. 2389 (2010) at §211.

[12] Staff of the J. Comm. on Taxation, 111th Cong., Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment of H.R. 1586, Scheduled for Consideration by the House of Representatives on August 10, 2010, 4-6 (Comm. Print 2010) available at

[13] Id. at 13-16.

[14] Id. at 19.

[15] Id. at 24-26.

[16] Id. at 28.

[17] Id. at 29.

[18] Id. at 33-35.

[19] Id. at 37.

[20] Any public policy arguments referring to HR 4213 also apply to HR 5893 since these arguments were in favor or opp osition of the bill based on the targeted tax cuts or changes in international tax rules.

[21] Tax Policy Center, "2011 Budget - Reform U.S. International Tax System",; Citizens for Tax Justice, Position Paper,; Letter to Congress from National Women's Law Center, available at

[22] U.S. Chamber of Commerce, "Letter Opposing H.R. 4213",; The Heritage Foundation, "Routine Tax Extenders Package Contains New Irresponsible Spending and Tax Hikes",; National Foreign Trade Council, Position Paper,; Americans for Tax Reform, ATRF Analysis,

[23] Letter to Congress from National Women's Law Center, available at

[24] See Testimony of Peter Orszag before Sen. Budget Comm., "Promoting Fiscal Discipline and Broad-Based Economic Growth" 11 (2006) available at

[25] See Testimony of Mark Zandi before the H. Budget Comm., "Perspectives on the Economy" (2010) available at

[26] U.S. Chamber of Commerce, "Letter Opposing H.R. 4213",

[27] Council on Foreign Relations, "U.S. Multinationals and Tax Reform",

[28] Gary Clyde Hufbauer & Theodore Moran, "Hobbling Exports and Destroying Jobs",

[29] National Association of Manufacturers, "Letter Opposing H.R. 5893",

[30] The Heritage Foundation, "Routine Tax Extenders Package Contains New Irresponsible Spending and Tax Hikes",

[31] Promote America's Competitive Edge, "Letter Opposing H.R. 5893",

[32] Mihir A. Desai, Taxing Multinational Firms: Securing Jobs or the New Protectionism?, 14 (2008), (Follow "Education Program" hyperlink; then "View Education by Title" hyperlink).

[33] Council on Foreign Relations, "U.S. Multinationals and Tax Reform",

[34] Desai, supra note 41, at 17.


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