Foreign Tax Credit Utilization: Have your cake and eat it too
By Bryant Andrus
Foreign tax credits are generated when a taxpayer moves from one jurisdiction to another, then is required to pay taxes to the previous jurisdiction. These taxes arise from various situations, including but not limited to: the unwinding of retirement accounts, withholding of pensions, withholding tax on dividends, selling businesses, selling real estate in the other non-U.S. jurisdiction, etc. The United States Internal Revenue Code (IRC) categorizes these foreign taxes paid to a foreign jurisdiction as foreign tax credits; they then can be used as a credit against future income. A key feature is that the IRC allows these foreign tax credits to be carried forward up to 10 years.
A critical part of foreign tax credit investing is how the IRC segments the foreign taxes paid into two buckets: General and Passive. In simplest terms, the Passive bucket is paid taxes attributed to capital gains, interest, rents, royalties, and dividends. The General Limitation bucket is paid taxes for all sources that are not considered passive. To utilize foreign tax credits against current or future income, the taxpayer must earn the correct type of income; Foreign Sourced Income (FSI). FSI is income that is derived from non-U.S. sources. Additionally, the FSI needs to be categorized or derived from the same bucket from which the foreign tax credit carried forward from. Thus, passive foreign-sourced income is necessary to utilize passive foreign tax credits, and one needs to generate general limitation FSI to offset general limitation foreign tax credits. Please note, it is in the IRS’s interest to categorize as many types of paid foreign taxes as a general limitation as possible; since it is more challenging for the individual to generate the general limitation FSI to offset those tax credits.
As you map out your investment portfolio, you create an asset allocation of stocks and bonds. A traditional liquid investment portfolio will generate three types of income: capital gains, dividends, and interest. One may think that a simple way to generate foreign source income is to allocate your stocks and bonds to non-U.S. companies. On the surface, this strategy makes sense. However, there is a couple of crucial points that need to be addressed.
Under the U.S.-Canada tax treaty and many other tax treaties with the U.S., capital gains are sourced to the country of residency. Although a realized capital gain on a foreign stock or bond might be considered derived from non-U.S. sources, the IRC says that capital gains are U.S. sourced capital gain regardless of where the company is located. Thus, capital gains are not considered foreign source income.
Dividends are considered foreign source income. Thus, if you receive a dividend from ABC Canada Inc, headquartered in Midtown, Canada; this would be regarded as passive FSI. This is great! However, under the IRC rules, current foreign taxes paid have to be used before carrying forward foreign tax credit. The mathematics can work out that you are only using about 85% of your forward-carried credits that you otherwise would be able to use and, as such, would then run the risk of having too many carried credits to utilize before they expire. It is a math exercise combined with forecasting of dividend rates from publicly traded companies. But something is better than nothing.
Bonds are the 3rd component of the income within a financial portfolio. Bonds pay interest. Under many treaties, specifically the U.S.-Canada tax treaty, there is no withholding on interest payments derived from Canada when pain a U.S. person. Unlike the dividends that attract current year withholding, you are able to use 100% of the foreign source income to utilize the foreign tax credit. The downside to relying only on interest is that we are in a very low-interest-rate environment. This means that unlike previous cycles in the credit markets, depending on interest coupons from bonds may not be feasible if your goal is to utilize all of your foreign tax credits.
The last issue with foreign tax credit utilization is the problem with general limitation foreign tax credits. As mentioned before, financial portfolios produce passive foreign source income. Things like unwinding retirement accounts, asset sales of businesses, etc., attract general limitation foreign taxes paid and require general limitation foreign-sourced income to utilize these credits. General limitation for source income can be very typical degenerate unless you are running an active business. However, if you are running an active business, then under the treaties, there will be tax payable on business profits, thus creating more foreign taxes paid.
What is the solution?
By creating the tax, legal, and finance overlap, we can optimize the foreign tax credit utilization strategies. By creating the synergies between the three respective disciplines, State Bird Corp now can create opportunities for investors to earn rates higher than public market bonds, enjoy the tax treatment of either passive or general limitation foreign source income, enjoy no withholding on the distributions, and have the certainty how the IRS will treat the income show that 100% of the income earned is in the right bucket and earning a reasonable rate of return.
To schedule your initial consultation, please contact us at info@statebirdcorp.com so that we can help you create a plan as unique as your fingerprint.
State Bird Corp is a management and financial consulting firm. State Bird Corp is not an accounting, legal or investment advisory firm. Any recommendation, inferences, or other guidance contained herein is meant for educational or general purposes and should not relayed upon as specific advice for any person or business. Consult your legal, tax, and investment advisor for specific recommendation to your situation. State Bird Corp is the managing member of SBC Investment Finance I, LLC, a special purpose finance company. SBC Investment Finance was created for the purpose of utilizing clients’ foreign taxes paid.