What Was Section 902 and Why Does It Still Matter?

Before its repeal, Section 902 of the Internal Revenue Code was a feature of the United States’ international tax system for corporations. Under the worldwide tax system that existed for decades, U.S. corporations were taxed on their income from all sources, including dividends from foreign affiliates. Since those affiliates had already paid income taxes in their home countries, this could result in the same income being taxed a second time by the U.S.

Section 902 provided a mechanism to mitigate this outcome by allowing a U.S. parent corporation to claim an “indirect” or “deemed paid” foreign tax credit for the foreign income taxes paid by its subsidiary. The provision was based on the principle that the dividends were paid from earnings already subject to foreign tax. By treating the U.S. parent as if it had paid those foreign taxes itself, Section 902 helped equalize the tax treatment between domestic and foreign operations.

The Pre-Repeal Deemed Paid Credit System

To qualify for the deemed paid credit, a U.S. domestic corporation had to own at least 10% of the voting stock of a foreign corporation from which it received a dividend. This ownership threshold targeted U.S. companies with a significant interest in their foreign subsidiaries, rather than passive portfolio investors.

For tax years after 1986, the system used a “pooling” concept for calculating the credit. Corporations were required to maintain multi-year pools of “post-1986 undistributed earnings” and “post-1986 foreign income taxes.” When a dividend was paid, it was treated as coming from this entire pool of accumulated earnings, and the credit was calculated based on the average effective tax rate of the tax pool. This approach prevented companies from timing dividend distributions to maximize their credits by selectively repatriating earnings from high-tax years.

The rules also extended to lower-tier foreign corporations. If a U.S. parent owned a first-tier foreign subsidiary that in turn owned a second-tier foreign subsidiary, the taxes paid by the second-tier entity could also be claimed as a credit. This system allowed deemed paid credits to flow up a chain of ownership, provided certain ownership thresholds were met at each level.

Calculating the Historical Credit

The Section 902 deemed paid credit was calculated using a specific formula that linked the dividend received to the subsidiary’s accumulated earnings and taxes. This formula determined the portion of the foreign subsidiary’s tax pool attributable to the dividend paid to the U.S. parent.

The formula was: Deemed Paid Credit = (Dividend / Post-1986 Undistributed Earnings Pool) x Post-1986 Foreign Income Taxes Pool. The “Dividend” was the amount distributed to the U.S. parent. The “Post-1986 Undistributed Earnings Pool” represented the total accumulated profits of the foreign subsidiary not yet distributed, calculated after subtracting foreign taxes. The “Post-1986 Foreign Income Taxes Pool” was the total income taxes paid by the subsidiary on those earnings.

For example, consider a U.S. parent, “US Corp,” that owns 100% of a foreign subsidiary, “ForCo.” ForCo has a post-1986 undistributed earnings pool of $800,000 and has paid $200,000 in foreign income taxes. In the current year, ForCo pays a dividend of $160,000 to US Corp.

The deemed paid credit would be calculated as: ($160,000 Dividend / $800,000 Earnings Pool) x $200,000 Tax Pool. This results in a $40,000 deemed paid foreign tax credit for US Corp. US Corp would report the $160,000 dividend as income and also include the $40,000 credit amount in its income, a process known as a “gross-up” under Section 78. The total reported income would be $200,000, and the $40,000 credit could then be used to offset U.S. tax.

Repeal by the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act of 2017 (TCJA) reshaped U.S. international taxation, with a central element being the repeal of Section 902. This change was effective for the tax years of foreign corporations beginning after December 31, 2017.

The primary reason for the repeal was the TCJA’s introduction of a “participation exemption” system. This shifted the U.S. toward a quasi-territorial system where most foreign-source dividends received by U.S. corporations are exempt from U.S. taxation. Because these dividends are no longer subject to U.S. tax, a credit for foreign taxes paid on those earnings became unnecessary.

The Modern Foreign Tax Credit Framework

With the repeal of Section 902, the TCJA established a new framework for taxing foreign earnings. The first component is a 100% dividends-received deduction (DRD) under Section 245A. This provision allows a domestic C corporation to deduct the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation,” effectively exempting those dividends from U.S. tax. This participation exemption is why the Section 902 credit for dividends is no longer needed.

The second component is a revised foreign tax credit system under Section 960, which now governs deemed paid credits. Unlike the old system that tied credits to dividends, the modern Section 960 ties credits to specific income categories that a U.S. shareholder must include in its income before the cash is distributed. These mandatory inclusions are primarily traditional Subpart F income and a new category known as Global Intangible Low-Taxed Income (GILTI).

When a U.S. corporation has a Subpart F or GILTI inclusion, it is deemed to have paid the foreign income taxes attributable to that specific income. This is a change from the pre-TCJA pooling method, as the new system requires a more direct tracing of taxes to the income that triggered the U.S. tax liability. For GILTI inclusions, the available credit is further limited, as only 80% of the foreign taxes paid on GILTI are creditable.

Lingering Importance of Historical Rules

Despite its repeal, the rules of former Section 902 continue to have practical relevance. The historical rules remain important for Internal Revenue Service (IRS) examinations of corporate tax returns for any tax year of a foreign corporation beginning on or before December 31, 2017. Any adjustments for a pre-TCJA year are determined under the old law, requiring companies to substantiate the original Section 902 credit calculations.

Similarly, a foreign tax redetermination for a pre-TCJA year requires recalculating the Section 902 credit. This adjustment affects the U.S. parent’s prior-year tax liability and the subsidiary’s earnings and profits pools carried forward.

Section 902 also remains relevant due to foreign tax credit carryforwards. Credits generated under the old system that were unused in pre-TCJA years can be carried forward for up to 10 years. However, these carryforwards must be properly allocated to the new foreign tax credit baskets created by the TCJA, such as the foreign branch and GILTI baskets. Using these carryforwards depends on correctly applying the transition rules that bridge the old and new systems.