What Is the High-Tax Kickout Treatment?
Learn about the U.S. tax rule that separates highly taxed foreign income, preventing the averaging of tax rates in foreign tax credit calculations.
The high-tax kickout is a provision in U.S. tax law that reclassifies certain foreign income. Its purpose is to prevent taxpayers from using high foreign taxes paid on one stream of income to reduce their U.S. tax liability on other, lower-taxed foreign income. Specifically, it targets passive income, such as interest and dividends, that has been taxed by a foreign country at a rate higher than the top U.S. tax rate. This prevents an outcome where high foreign taxes could artificially inflate the amount of foreign tax credits available to offset U.S. taxes on other passive earnings.
The Foreign Tax Credit Limitation and Income Baskets
The U.S. foreign tax credit (FTC) mitigates the double taxation of income earned abroad by allowing a credit for foreign taxes paid. Under Internal Revenue Code Section 904, this credit is limited to the amount of U.S. tax that would have been paid on that foreign income. This limitation prevents a taxpayer from using foreign tax credits to reduce U.S. tax on U.S. source income.
To enforce this limitation, the FTC is calculated separately for different “baskets” of foreign income, which prevents averaging high and low tax rates. The primary income categories include general, foreign branch, and passive income. Each basket has its own FTC limitation calculation, requiring taxpayers to allocate deductions to the income in each category.
The high-tax kickout rule applies to the passive income basket. This basket includes income not derived from an active business, such as interest, dividends, royalties, and certain rents. For instance, dividend income a U.S. corporation receives from a foreign subsidiary would fall into the passive category.
Applying the High-Tax Kickout Test
The high-tax kickout test is applied on an item-by-item basis to income within the passive category. The core of the test is a direct comparison between the rate of foreign tax paid and the highest applicable U.S. tax rate. If the foreign income taxes paid or accrued on an item of net foreign passive income exceed the U.S. tax that would be due on that same income, it is designated as high-taxed income. This determination is made after allocating and apportioning expenses to the gross passive income item.
The specific calculation involves multiplying the net amount of foreign passive income by the highest U.S. tax rate applicable to that taxpayer. For a corporation, this would be the top corporate tax rate under Section 11 of the Internal Revenue Code. For an individual, the highest rate specified in Section 1 would be used.
For instance, consider a U.S. corporation that receives $1,000 in passive dividend income from a foreign country. After allocating expenses, the net income is $800. The corporation paid $250 in foreign income taxes on this dividend. If the highest U.S. corporate tax rate is 21%, the U.S. tax would be $168 ($800 x 0.21). Since the $250 of foreign tax paid is greater than the $168 of U.S. tax, the income fails the test and is “kicked out” of the passive basket.
This test is performed on Form 1116, Foreign Tax Credit, for individuals, estates, and trusts, and on Form 1118 for corporations.
Consequences of the Kickout
When an item of passive income is determined to be high-taxed, it is removed from the passive category basket. This kicked-out income and its associated taxes are moved into the general category income basket. This re-categorization is the primary consequence of failing the test.
By moving the high-taxed income and its corresponding taxes to the general basket, the taxpayer can no longer average those high taxes with other low-taxed passive income. This often leads to a lower overall foreign tax credit limitation for the passive basket, potentially resulting in a portion of the foreign taxes paid on other passive income becoming non-creditable in the current year.
On Form 1116 or 1118, the taxpayer must enter the amount of foreign taxes related to the kicked-out income as a negative number for the passive category. Subsequently, that same amount is entered as a positive number for the general category income.