What Is a Section 78 Dividend Gross-Up?

Internal Revenue Code Section 78 impacts U.S. corporations with financial ties to foreign subsidiaries. This rule works with the foreign tax credit system and addresses how income from a foreign corporation is reported by its U.S. parent company. The mechanism involves adding a “phantom” amount to a corporation’s income.

The function of Section 78 is to adjust the taxable income of a domestic corporation that receives dividends from its foreign affiliates when it chooses to claim credits for foreign taxes paid by its subsidiary. This income modification standardizes the treatment of foreign earnings, making them similar to income generated through a direct branch operation.

The Section 78 Gross-Up Explained

A Section 78 gross-up requires a domestic corporation to increase its reported dividend income by the amount of foreign taxes its subsidiary paid on the underlying earnings. This is not a cash dividend; the U.S. parent does not receive any additional money. Instead, it is a notional, or “phantom,” amount of income that must be included on the U.S. corporation’s tax return. While this gross-up amount is treated as dividend income, it is not eligible for certain tax benefits, such as the deduction available for other foreign dividends.

The purpose of this gross-up is to prevent what would otherwise be a double tax benefit. Without it, a U.S. corporation could receive a dividend from its foreign subsidiary out of after-tax earnings and also claim a credit for the foreign taxes paid on those same earnings. This would allow a deduction for foreign taxes at the subsidiary level and a credit for them at the parent level. The gross-up neutralizes this by adding the foreign taxes back into the U.S. parent’s income, making the dividend taxable on a pre-tax basis.

Triggers for a Section 78 Dividend

The requirement to report a Section 78 dividend is triggered when a domestic C corporation, which must own at least 10% of a foreign corporation, chooses to claim a foreign tax credit for taxes its subsidiary has paid. These are known as “deemed-paid” or “indirect” credits. If the domestic corporation chooses to deduct foreign taxes instead of crediting them, the Section 78 gross-up does not apply.

U.S. corporations can now often claim a 100% deduction on dividends received from their foreign subsidiaries. When a corporation takes advantage of this deduction for a cash dividend, it is not permitted to claim a foreign tax credit on that income. As a result, the Section 78 gross-up is no longer common for actual dividend payments.

The Section 78 gross-up now applies primarily to other types of foreign income. The most common triggers are deemed income inclusions under the Subpart F and Global Intangible Low-Taxed Income (GILTI) rules. These rules require U.S. shareholders to include certain foreign earnings in their income, even if no cash dividend is distributed. When a corporation has a Subpart F or GILTI inclusion and claims a deemed-paid credit for the associated foreign taxes, it must also report a corresponding Section 78 dividend.

Calculating the Gross-Up Amount

Consider a scenario with a U.S. parent company and its wholly-owned foreign subsidiary. The foreign subsidiary earns $1,000,000 in pre-tax profits in a country with a 20% corporate income tax rate. The foreign subsidiary pays $200,000 ($1,000,000 x 20%) in foreign income taxes, leaving it with $800,000 in after-tax earnings and profits. The subsidiary then distributes the entire $800,000 to its U.S. parent as a dividend.

The next step is to determine the foreign taxes “deemed paid” by the U.S. parent. Since the U.S. parent received 100% of the subsidiary’s after-tax earnings as a dividend, it is deemed to have paid 100% of the foreign taxes associated with those earnings. In this case, the deemed-paid foreign tax credit is the full $200,000 of taxes paid by the subsidiary.

This deemed-paid tax amount is precisely the Section 78 dividend gross-up. The U.S. parent corporation must add this $200,000 to its taxable income. The total taxable income from this event is $1,000,000, which is calculated as the $800,000 actual dividend received plus the $200,000 Section 78 gross-up. This brings the subsidiary’s pre-tax earnings onto the U.S. parent’s return.

Reporting Requirements and Tax Forms

The Section 78 dividend amount must be reported to the IRS on Form 1118, “Foreign Tax Credit – Corporations.” This form is used by corporations to compute and claim the credit for foreign taxes paid or accrued.

The Section 78 dividend is reported on Schedule A of Form 1118, titled “Taxable Income or (Loss) From Sources Outside the United States.” The gross-up amount is included as a type of foreign-source dividend income and is combined with the actual dividend received from the foreign corporation. This combined total helps determine the foreign-source taxable income, a key figure in calculating the foreign tax credit limitation.

The amount reported as a Section 78 dividend on Schedule A corresponds to the deemed-paid foreign taxes being claimed as a credit. The deemed-paid taxes themselves are calculated on Schedule B of Form 1118, “Foreign Income Taxes Deemed Paid.” The total from Schedule B flows into the main credit calculation, while the Section 78 amount from Schedule A ensures that the income side of the equation is correctly stated.