IRC 78: How the Gross-Up for Deemed Paid Foreign Tax Credit Works

The Internal Revenue Code (IRC) Section 78 plays a key role in international taxation by addressing the gross-up for deemed paid foreign tax credits. This mechanism allows U.S. corporations to claim foreign taxes paid by their subsidiaries as if they were directly incurred, impacting overall tax liability. Understanding how IRC Section 78 functions is essential for global companies to ensure compliance and optimize tax strategies.

Corporate Requirements

Applying IRC Section 78 requires meeting specific corporate requirements. To claim a gross-up for deemed paid foreign tax credits, a U.S. corporation must own at least 10% of the voting stock in a foreign corporation. This ownership threshold establishes eligibility to claim foreign taxes paid by subsidiaries.

Corporations must maintain thorough documentation of foreign taxes paid, including details on the nature, amount, and jurisdictions involved. Accurate records are crucial, as they form the basis for calculating the gross-up and substantiating claims to the IRS. Insufficient documentation can result in disallowed credits and increased tax liabilities.

Timely filing of Form 1118 is required to claim the foreign tax credit. This form provides information on foreign taxes paid, the gross-up amount, and the credit calculation. Accurate and consistent reporting is essential to avoid penalties or audits.

Calculation for the Gross-Up

The gross-up calculation under IRC Section 78 involves adding back deemed paid foreign taxes to foreign source income. This adjustment reflects the pre-tax income equivalent, as if the foreign taxes had not been paid. The gross-up is determined by dividing foreign taxes deemed paid by the foreign corporation’s post-tax earnings and profits.

For example, if a U.S. corporation owns 15% of a foreign subsidiary that paid $100,000 in foreign taxes with post-tax earnings and profits of $400,000, the gross-up amount would be $125,000. This amount is then added to the U.S. corporation’s foreign source income, increasing the base for calculating the foreign tax credit.

Precise documentation is essential to support the gross-up calculation. Corporations must keep records of foreign taxes paid and earnings and profits. Changes in foreign tax rates or U.S. tax laws may also affect these calculations, requiring companies to stay informed.

Coordination With Section 901

The interaction between IRC Section 78 and Section 901 is critical for ensuring an accurate foreign tax credit. Section 901 allows U.S. taxpayers to claim credits for foreign income taxes paid, mitigating double taxation. The gross-up under Section 78 increases foreign source income, which directly impacts the foreign tax credit calculation.

A precise integration of the gross-up into the Section 901 calculation is necessary to determine the allowable credit. The foreign tax credit is limited to the lesser of foreign taxes paid or the U.S. tax on foreign source income. This requires careful computation to avoid errors or disallowed credits.

The inclusion of the gross-up also affects the foreign tax credit carryback and carryforward provisions. When unused credits exceed the limitation, they can be carried back one year or forward up to ten years. The gross-up influences these calculations, impacting long-term tax planning strategies.

Earnings and Profits Adjustments

Adjusting earnings and profits (E&P) is a necessary step for international taxation. E&P determines a corporation’s capacity to pay dividends and is critical in tax calculations. U.S. corporations must adjust their E&P to accurately reflect the earnings of foreign subsidiaries. This includes converting foreign earnings into U.S. dollars and accounting for deferred foreign taxes.

Adjustments must also reconcile differences in accounting standards, such as GAAP versus IFRS, and account for foreign exchange gains or losses. These factors ensure that E&P calculations are consistent and accurate for tax purposes.

Reporting on the Tax Return

Accurate reporting of the gross-up and foreign tax credit is essential for compliance. Corporations must use Form 1118, “Foreign Tax Credit – Corporations,” to disclose foreign taxes paid, the gross-up amount, and the credit calculation. Proper allocation of the gross-up to the correct income categories, such as passive or general income, is necessary to avoid errors or disallowed credits.

The gross-up amount must also be integrated into Form 1120, the U.S. Corporation Income Tax Return, as part of foreign source income. Consistency between Form 1118 and Form 1120 is critical to prevent discrepancies that could trigger IRS scrutiny. Supporting schedules detailing foreign taxes paid and corresponding earnings and profits must align with reported figures.

Corporations should also ensure compliance with electronic filing requirements to avoid delays or penalties. Proper reporting safeguards against audits and ensures that claims for foreign tax credits are processed efficiently.