What Is a Sec 78 Gross Up for the Foreign Tax Credit?

A Section 78 gross-up is an amount a U.S. corporation must include in its taxable income when claiming a credit for foreign taxes paid by its overseas subsidiaries. This mechanism, found in Section 78 of the Internal Revenue Code, treats the foreign taxes paid by the subsidiary as an additional dividend to the U.S. parent company.

The purpose of this rule is to create tax parity between operating abroad through a subsidiary versus a foreign branch. The gross-up prevents a more favorable outcome for subsidiaries by adding the foreign tax amount back into the U.S. parent’s income, ensuring the U.S. tax base reflects the subsidiary’s pre-tax foreign earnings.

The Foreign Tax Credit Connection

When a U.S. corporation receives income from foreign sources, it faces potential double taxation. To mitigate this, the Internal Revenue Code provides a choice: the corporation can either deduct the foreign income taxes paid or claim a credit for them. A credit provides a dollar-for-dollar reduction of the U.S. income tax liability, often making it a more valuable option.

The need for a Section 78 gross-up arises when a U.S. corporation claims the foreign tax credit for taxes paid by its foreign subsidiary, known as an “indirect” or “deemed-paid” credit. Under Section 960 of the tax code, a U.S. corporate shareholder that owns at least 10 percent of a foreign corporation may treat the foreign income taxes paid by that subsidiary as if it had paid them directly. This applies to taxes on earnings distributed as a dividend or included in income through anti-deferral regimes like Subpart F or Global Intangible Low-Taxed Income (GILTI).

If a corporation elects to take this credit, it must “gross up” its income by the amount of the foreign taxes being claimed. For GILTI inclusions, while the income is grossed up by the full amount of foreign taxes, the allowable foreign tax credit is limited to 80% of those taxes.

Calculating the Section 78 Gross-Up

The gross-up amount is equal to the foreign income taxes paid by the foreign subsidiary on the earnings from which a dividend is distributed. This calculation ensures the U.S. parent corporation’s taxable income reflects the full pre-tax earnings of its subsidiary.

For example, suppose a U.S. parent company, “ParentCo,” wholly owns a foreign subsidiary, “SubCo.” SubCo earns $10,000 in profits and pays $2,000 in foreign income taxes, leaving it with $8,000 in after-tax earnings which it distributes to ParentCo as a dividend.

When ParentCo receives the $8,000 cash dividend, it also chooses to claim a deemed-paid foreign tax credit for the $2,000 in taxes that SubCo paid. To do this, ParentCo must perform a Section 78 gross-up of $2,000. For U.S. tax purposes, ParentCo reports $10,000 of dividend income, calculated as the $8,000 dividend plus the $2,000 gross-up. This $10,000 figure represents SubCo’s pre-tax earnings that generated the dividend.

Reporting and Tax Impact

The Section 78 gross-up calculation affects both gross income and the foreign tax credit computation. The gross-up amount is reported as dividend income on a corporation’s U.S. income tax return, Form 1120.

Using the previous example, ParentCo would include the $10,000 of grossed-up dividend income in its calculation of total taxable income. Assuming a 21% U.S. corporate tax rate, this income would generate a tentative U.S. tax of $2,100.

Simultaneously, the $2,000 gross-up amount is added to the foreign taxes available for credit on Form 1118, Foreign Tax Credit—Corporations. After calculating its tentative U.S. tax, ParentCo can then use the $2,000 foreign tax credit to offset this liability. The U.S. tax of $2,100 is reduced by the $2,000 credit, resulting in a final U.S. tax of $100 on that foreign income.