We are often asked whether unutilized foreign tax credits in the U.S. tax return are going to be able to be used in the future.
Under the Internal Revenue Code (IRC) excess foreign tax credits can be carried forward for up to ten years and back for one year.
Whether the taxpayer can utilize foreign tax credits (whether current year’s, prior year’s or the following year’s tax credits) will depend on the numbers making up the current year’s return including the ratio of foreign-sourced income to U.S.-sourced, the type of tax credits (credits on foreign earned income are grouped and carried forward or back separately to credits for foreign passive income), as well as the amount of foreign tax credits available.
Foreign tax credits expire after ten years, not providing the taxpayer with any benefit.
As this occurs on a FIFO (first in, first out) basis, in other words, credits from the earliest years will expire first, tracking of foreign tax credits and the years to which they relate is mandatory.
In New Zealand, due to our marginal individual income tax brackets progressively taxing income at a higher effective tax rate than if the income were taxed on the U.S. individual income tax scale, the U.S. tax liability on New Zealand-sourced income is usually less than New Zealand income tax paid on that income. As a result, New Zealand based individuals regularly have excess foreign tax credits to carry forward in their U.S. tax return. That occurs up to a certain level of taxable income in the U.S. tax return, when a higher marginal individual income tax rate in the U.S. applies, being 35% up to 39.6%, and dependent on the filer’s filing category.
Whilst foreign tax credits provide a greater reduction in U.S. income tax liability on foreign earned income than taking a deduction from gross income for the foreign tax paid does, there are limited occasions when it may be worthwhile to file an amended return to take a deduction rather than a credit.
The rationale behind this is that at one point in time it may appear more tax-efficient to take a credit than a deduction, but this can change as the taxpayer’s future years’ tax returns are prepared. For example, it may work out more tax-efficient over a number of years to carry-forward, rather than claim foreign tax credits, take a deduction in one year and foreign tax credits in a future year. By deducting in one year instead of taking tax credits, those foreign tax credits are effectively preserved for future years. This may be an effective technique if an individual is moving from a higher taxing jurisdiction to a lower taxing jurisdiction, where not as many foreign tax credits are being accrued. No-one can say what will happen in the future, and it may become more beneficial to revisit a prior year’s return and change from deduction to credit or vice-versa. Complicating this is the foreign earned income exclusion, arguably the most widely used technique to report foreign earned income.
Tax efficiency becomes exponentially more complicated when other carry-forward and carry-back rules affect multiple years, in turn affecting whether it is more efficient to take a credit or a deduction for foreign taxes.
Examples include capital loss carry-forwards and net operating loss carry-forwards and carry-backs.
Exacerbating this are the limitations on claiming foreign tax credits – the main one being the ratio of foreign-sourced income to U.S.-sourced income.
The Internal Revenue Service (IRS) has looked at the issue of electing to revisit prior years’ returns and change the method of claiming foreign taxes (deduction or credit) in recent years. Three pronouncements on the matter have been issued by the Chief Counsel.
CCA 201204008 was issued in 2012 where the IRS restricted the ability to change between deductions and a credit for foreign taxes to a one-way street. That is, the change may only be made from a deduction to a credit, and not from a credit to a deduction.
CCA 201330031 was issued in 2013 and CCA 201517005 in 2015. Both advices reinforce the IRS’ position on this matter. Whilst a specific section of the IRC, section 904(c) allows the carry-forward of foreign tax credits for up to ten years, CCA 201330031 falls back on the three year statute of limitations, and on that basis the IRS has declined to issue refunds based on an election to deduct, rather than credit, foreign taxes paid where the claim is made greater than three years after the filing of the original return.
The issue at stake relates to a related section in the IRC, Section 6511(d)(3) which states:
(3) Special rules relating to foreign tax credit.
(A) Special period of limitation with respect to foreign taxes paid or accrued. If the claim for credit or refund relates to any overpayment attributable to any taxes paid or accrued to any foreign country or to any possession of the United States for which credit is allowed against the tax imposed by subtitle A in accordance with the provisions of section 901 or the provisions of any treaty to which the United States is a party, in lieu of the 3-year period of limitation prescribed in section (a), the period shall be 10 years from the date prescribed by law for filing the return for the year in which such taxes were actually paid.
This article has been written for general interest. It does not contain answers to specific situations and it is, therefore, essential to treat it as a prompt to take specific advice on any real and particular issues. We accept no responsibility for any action taken by a reader who relies on the article but does not seek further advice to answer any specific query.