How Section 904(h) Affects the Foreign Tax Credit

U.S. corporations with international operations may have their foreign earnings taxed twice: once by the foreign country and again by the United States. To address this, the U.S. tax code provides a foreign tax credit, limited to the U.S. tax on a company’s foreign-source income. Section 904(h) provides rules for sourcing income under U.S. tax treaties, which directly affects the credit’s limitation by determining if income is U.S. or foreign source.

A component of this system is the deemed-paid, or indirect, foreign tax credit. This mechanism allows a domestic parent corporation to claim a credit for foreign income taxes paid by its foreign subsidiaries, treating the parent as if it had paid the taxes itself. This credit is a dollar-for-dollar reduction of the U.S. income tax liability.

Qualifying for the Indirect Foreign Tax Credit

To be eligible for the indirect foreign tax credit, a domestic corporation must own at least 10% of the voting stock of the foreign corporation from which it has certain income inclusions. This threshold ensures the credit is available to U.S. corporations with a significant interest in a foreign subsidiary, rather than those with minor portfolio investments.

A Controlled Foreign Corporation (CFC) is a foreign corporation where U.S. shareholders own more than 50% of the stock by vote or value. For this purpose, a U.S. shareholder is a U.S. person owning 10% or more of the foreign corporation’s stock. The indirect credit rules are tied to the CFC regime, as the credit often applies to income U.S. shareholders must report from their CFCs, even if no cash dividend is paid.

The ownership requirements extend beyond a direct parent-subsidiary relationship through a tier system. This allows a U.S. corporation to claim a credit for taxes paid by lower-tier foreign corporations. The 10% ownership test must be met at each level of the ownership chain. For example, if a U.S. parent owns 50% of a first-tier foreign subsidiary, and that subsidiary owns 40% of a second-tier foreign subsidiary, the parent’s indirect ownership is 20% (50% of 40%). This exceeds the 10% threshold, allowing the parent to claim a credit for taxes paid by the second-tier subsidiary.

The Deemed Paid Credit Calculation

Following the Tax Cuts and Jobs Act of 2017, the former system of pooling foreign taxes and earnings was repealed. Deemed-paid credits are now determined on a current-year basis and are associated with specific categories of income inclusions from foreign subsidiaries.

The credit is available for foreign taxes paid on income U.S. shareholders must recognize under anti-deferral regimes, such as Subpart F inclusions and Global Intangible Low-Taxed Income (GILTI). Deemed-paid credits are generally not available for actual dividends, as a 100% dividends-received deduction often eliminates the U.S. tax liability and the need for a credit.

The Section 78 “gross-up” requires the U.S. corporation to increase its taxable income by the amount of the deemed-paid credit it claims. The purpose is to prevent the corporation from receiving a double benefit: a credit for the foreign taxes and a deduction for those same taxes by not including them in income. The grossed-up amount is treated as a dividend received from the foreign subsidiary.

For example, a U.S. corporation has a GILTI inclusion of $80,000 from its foreign subsidiary, which paid $20,000 in foreign income taxes. If the deemed-paid credit attributable to the GILTI inclusion is $16,000, the U.S. corporation must add this amount to its taxable income. The corporation then reports $96,000 of income ($80,000 GILTI + $16,000 gross-up) and claims a $16,000 foreign tax credit.

Information and Documentation for Form 1118

To claim the indirect foreign tax credit, a corporation must file Form 1118, Foreign Tax Credit—Corporations, with its U.S. income tax return. Proper completion of this form requires gathering the following documentation:

• The foreign corporation’s name, address, and tax identification number
• Financial statements to determine the foreign corporation’s earnings and profits
• Proof of foreign tax payments, such as tax receipts
• Records detailing Subpart F or GILTI inclusions
• The applicable exchange rates for converting foreign currency to U.S. dollars

The gathered information is used to complete the form’s schedules. For instance, Schedule C is used to compute taxes deemed paid for Subpart F inclusions, while Schedule D is for GILTI-related deemed paid taxes.

Claiming the Credit on a Corporate Tax Return

Once Form 1118 is completed, it must be attached to the corporation’s main income tax return, Form 1120. The form serves as the supporting documentation for the foreign tax credit claimed. The total credit amount from Form 1118 is carried over to the appropriate line on Form 1120.

For corporations filing electronically, the completed Form 1118 and its schedules are included in the e-filing package. If filing a paper return, Form 1118 should be attached to Form 1120 in the order specified by IRS instructions. Including all required schedules is necessary to avoid processing delays.

After filing, the foreign tax credit is applied against the corporation’s U.S. tax liability. If the credit exceeds the U.S. tax liability for the year, the excess can be carried back one year and forward for up to ten years. However, excess credits from the GILTI category cannot be carried back or forward.