Treas. Reg. §1.960-1: Deemed Paid Foreign Tax Credits

Internal Revenue Code Section 960 allows a U.S. corporation that is a shareholder of a controlled foreign corporation (CFC) to receive a “deemed paid” foreign tax credit. This credit applies to foreign income taxes the CFC has paid on earnings that the U.S. shareholder must include in its taxable income. The detailed rules for calculating this credit are in Treasury Regulation §1.960-1, which provides the framework for determining the amount of foreign taxes a domestic corporation is considered to have paid.

The Tax Cuts and Jobs Act (TCJA) of 2017 reshaped these rules by introducing new categories of foreign income and altering the U.S. international tax system. The system moved from deferring tax on foreign earnings to taxing certain income annually. The regulations were updated to align with this new structure, establishing an annual approach to associating foreign taxes with specific income inclusions.

This framework is a departure from the pre-TCJA system, which pooled foreign taxes and earnings over multiple years. The current regulations require a year-by-year analysis to connect the foreign taxes paid by a CFC to the income that generates a U.S. tax liability for its shareholder.

Key Definitions and Income Grouping

The deemed paid credit calculation begins with categorizing a controlled foreign corporation’s (CFC) income into defined “income groups.” The process starts by identifying the CFC’s gross income and assigning it to a foreign tax credit limitation category, such as the general or passive category, as defined under Internal Revenue Code Section 904.

After assignment to a Section 904 category, the income is classified into more specific income groups. This classification dictates which foreign taxes can be associated with a U.S. shareholder’s income inclusion and claimed as a credit.

The “Subpart F income group” contains items classified as Subpart F income under Section 952. This includes passive-type income like dividends, interest, and royalties, along with certain sales and services income with related parties. The regulations require further separation within this group based on the specific type of Subpart F income.

The “tested income group” consists of the CFC’s gross income factored into the calculation of Global Intangible Low-Taxed Income (GILTI). Gross tested income is determined by subtracting certain items from the CFC’s total gross income, including Subpart F income and dividends from related persons. All items of gross tested income within a single Section 904 category are aggregated into one tested income group.

Any income that does not fall into a Subpart F or tested income group is placed into the “residual income group,” which captures any remaining earnings and profits of the CFC for the year. An aspect of this classification is that foreign taxes allocated to the residual income group are not eligible to be claimed as a deemed paid credit. This rule is because the initial classification directly determines the potential for tax credit relief, and income in the residual group does not result in a U.S. income inclusion.

Associating Foreign Taxes with Income Groups

After a CFC’s income is categorized, the next step is to associate the foreign income taxes it paid with those specific groups. This process involves allocating and apportioning the CFC’s “current year taxes” among the Subpart F, tested income, and residual income groups.

The process begins by identifying the foreign taxable income, under foreign law, that corresponds to the gross income in each U.S. income group. Deductions allowed under foreign law are then allocated and apportioned to this foreign gross income. This aligns the foreign taxes paid with the specific income streams that generated the tax liability in the foreign country.

Once the foreign taxable income in each group is determined, the current year’s foreign income taxes are apportioned. Taxes directly attributable to a specific income group, like a withholding tax on a royalty payment, are allocated to that group. Any remaining taxes are apportioned based on the relative amount of foreign taxable income in each group.

For example, assume a CFC has $1,000 of total foreign taxable income and pays $200 in foreign taxes. Its income is classified into a Subpart F group with $800 of foreign taxable income and a residual group with $200. The Subpart F income group would be associated with $160 of the foreign taxes ($200 ($800 / $1,000)), while the residual group is associated with the remaining $40. Only the $160 associated with the Subpart F group is potentially creditable.

This allocation mechanism ensures that only taxes paid on income subject to U.S. taxation under the Subpart F or GILTI regimes can give rise to a deemed paid credit. Taxes associated with the residual income group, representing income not currently taxed to the U.S. shareholder, are locked in that category and cannot be credited.

Calculating the Deemed Paid Credit

Once foreign taxes are associated with specific income groups, the final step is to calculate the amount of those taxes the U.S. shareholder can claim as a deemed paid credit. The regulations provide distinct formulas for inclusions under Subpart F and Global Intangible Low-Taxed Income (GILTI). These calculations are performed annually and are specific to each income group that gives rise to a shareholder’s income inclusion.

For a Subpart F inclusion, a domestic corporation is deemed to have paid foreign taxes equal to its share of the taxes allocated to the relevant Subpart F income group. This is calculated by multiplying the taxes associated with that group by a fraction. The numerator is the shareholder’s Subpart F inclusion from that group, and the denominator is the total net income in that same group.

For example, a U.S. shareholder (USP) wholly owns a CFC with a Subpart F income group containing $800 of net income and $160 of allocated foreign taxes. If USP has a Subpart F inclusion of $800 from this group, its deemed paid credit is the full $160, calculated as $160 multiplied by ($800 / $800).

The calculation for a GILTI inclusion follows a different formula. A domestic corporation is deemed to have paid foreign taxes equal to 80 percent of the product of its “inclusion percentage” and its “tested foreign income taxes.” Tested foreign income taxes are those attributable to a CFC’s tested income. The inclusion percentage is the shareholder’s GILTI inclusion amount divided by its aggregate share of the net tested income from all its CFCs.

For instance, assume USP’s GILTI inclusion is $500, and its share of net tested income is $625, making its inclusion percentage 80% ($500 / $625). If the tested foreign income taxes are $100, the deemed paid credit is $64, calculated as 0.80 (0.80 $100). The initial 80% factor in the formula acts as a haircut on the available foreign tax credits for GILTI.

Tracking Previously Taxed Earnings and Profits

After a U.S. shareholder has a Subpart F or GILTI inclusion, the underlying earnings of the controlled foreign corporation (CFC) become “Previously Taxed Earnings and Profits” (PTEP). The creation of PTEP is an accounting mechanism designed to prevent the same income from being taxed twice: once at the initial inclusion and again when the CFC makes an actual cash distribution to its shareholder.

The regulations require PTEP to be tracked in separate annual accounts. When an income inclusion occurs, the corresponding amount of the CFC’s earnings and profits is reclassified as PTEP and recorded in an account for that year. This PTEP must also be categorized into specific “PTEP groups” within each annual account.

These PTEP groups correspond to the character of the income that created them. For instance, PTEP from a GILTI inclusion is tracked in a §951A PTEP group, while PTEP from a Subpart F inclusion is tracked in a §951(a)(1)(A) PTEP group. This categorization preserves the character and foreign tax credit attributes of the income.

Under Internal Revenue Code Section 959, when the CFC later distributes cash, the shareholder can receive distributions from these PTEP accounts tax-free. The ordering rules dictate that distributions are sourced first from PTEP before other, non-taxed earnings. This system allows for the tax-free repatriation of foreign earnings already accounted for in the U.S. tax system.