Typically, to receive a Foreign Tax Credit (FTC), the U.S. taxpayer must have actually paid the foreign tax. However, an important exception applies when a U.S. corporation owns at least 10% of a foreign subsidiary. In this case, the foreign subsidiary, rather than the U.S. taxpayer, pays the tax. To avoid double taxation on foreign income, the U.S. government allows the U.S. parent to claim a deemed paid foreign tax credit under IRC §960 (previously under IRC §902 before the 2017 tax reform). This credit applies to the portion of foreign taxes paid by the subsidiary that is attributable to the earnings distributed to the U.S. parent.
For decades, this principle has been a cornerstone of U.S. international tax policy, ensuring that U.S. corporations with foreign subsidiaries can offset their U.S. tax liability using foreign taxes paid on those same earnings. However, legislative changes—especially post-2017—have reshaped the precise scope of “deemed paid” credits, introducing new complexities that taxpayers must navigate.
Overview: The Foreign Tax Credit (FTC)
Under U.S. tax law, American taxpayers (including corporations) are taxed on worldwide income—including income earned both domestically and abroad. Without relief, foreign earnings would face double taxation: first by a foreign country and then again by the U.S. To mitigate this burden, the foreign tax credit (FTC) allows eligible U.S. taxpayers to reduce their U.S. tax liability by the amount of qualifying foreign income taxes paid or accrued.
Direct Credits
A direct foreign tax credit arises if a U.S. taxpayer directly pays or accrues foreign income taxes. For example, when a U.S. corporation operates a foreign branch, and that branch pays withholding or income tax in the host country, the U.S. entity is treated as if it personally paid those foreign taxes. Typically, these direct credits come from taxes withheld at the source on royalties, interest, or service fees. For instance, if a foreign country levies a 10% withholding tax on royalty payments for IP licensed from a U.S. corporation, the U.S. corporation can claim a direct credit for the 10% tax—provided all other FTC requirements are satisfied (e.g., not disallowed under separate limitations).
Deemed Paid / Indirect Credits
Historically referred to as “§902 credits,” indirect credits apply when foreign subsidiaries pay local taxes on their earnings, which are later repatriated to the U.S. parent. Under the pre–Tax Cuts and Jobs Act (TCJA) regime, a U.S. parent that owned at least 10% of the foreign subsidiary’s voting stock was deemed to have paid a share of the subsidiary’s foreign taxes proportional to any dividends received. After the parent “grossed up” its dividend by those taxes, it could claim a credit. Following the 2017 TCJA, the rules evolved. While IRC §245A now grants a 100% dividends-received deduction (DRD) for certain post-2017 dividends—thus eliminating double taxation without needing an FTC—an indirect credit still applies to Subpart F inclusions and Global Intangible Low-Taxed Income (GILTI) under IRC §960. In these cases, the U.S. parent is deemed to have paid a proportional share of the foreign subsidiary’s taxes if it owns 10% or more of the subsidiary (by vote or value), ensuring no double tax occurs on these deemed inclusions.
Foreign Tax Credit: Key Concepts
According to Treas. Reg. §1.901-2(a), a foreign levy must be an income tax, war profits tax, excess profits tax, or a tax “in lieu” of such taxes to qualify as creditable under IRC §901. Effective from final regulations issued in 2022, these rules further clarify that foreign net income taxes generally need to mirror how U.S. net income taxes operate—meaning they must incorporate gross receipts, allowable deductions, and a tax base consistent with net income principles.
Digital Services Taxes (DSTs) or other levies that do not align with net income calculation may fail to qualify. Post-2022, the IRS has also demanded that a foreign levy meet certain nexus and cost recovery requirements to be treated as an income tax. If the foreign levy does not align with these new criteria, it may be disqualified from the FTC.
Foreign Tax Credit Limitations
Though the FTC can reduce the double-tax burden, it is subject to various limitations. Generally, the §904 limitation calculates how much foreign taxes can offset U.S. tax on foreign-source income. This is typically calculated by multiplying your total U.S. tax liability by the percentage of your total taxable income that comes from foreign sources.
A taxpayer may not credit more than the U.S. tax on that foreign income. If the foreign tax is higher, the taxpayer faces excess credits that can carry back one year and forward ten years for specific categories (though GILTI-related taxes do not allow carryovers). Post-TCJA, the law introduced separate “baskets” for items like GILTI, foreign branch income, passive income, and so forth. Credits generally cannot be used across baskets.
Recent Developments and Temporary Relief
2022 Final Regulations
In 2022, the Treasury Department and IRS finalized regulations tightening the criteria for what qualifies as an income tax for FTC purposes. The new rules require a foreign levy to closely resemble U.S. taxation of net income, including meeting jurisdictional and cost recovery tests. As a result, many U.S. corporations found themselves unable to credit certain foreign levies—such as Digital Services Taxes (DSTs) and other user-based taxes—under these stricter definitions.
Notice 2023-55
Acknowledging widespread industry concerns, the IRS issued Notice 2023-55 in July 2023, offering temporary relief from some of the newly tightened FTC rules for tax years beginning on or after December 28, 2021, and ending on or before December 31, 2023. This relief allows many taxpayers to follow pre-2022 standards for determining if a foreign tax is creditable, though Digital Services Taxes (DSTs) remain ineligible. In December 2023, the IRS issued Notice 2023-80, extending this relief to tax years ending before the date that a subsequent notice or other guidance withdrawing or modifying the temporary relief is issued, providing corporate taxpayers additional time to restructure or renegotiate certain foreign tax burdens or to clarify the local levy’s compliance with the U.S. net income concept.
Foreign Tax Paid on Dividends Post-2017
Following the introduction of IRC §245A, U.S. corporations that own at least 10% of a foreign corporation can often deduct 100% of qualifying foreign-source dividends, effectively exempting them from U.S. taxation. Because these dividends are not subject to U.S. tax, no Foreign Tax Credit (FTC) can be claimed on them. However, certain dividends, such as hybrid dividends under §245A(e), may still be taxable and could qualify for an FTC. Older earnings (pre-2018) that were not subject to the transition tax under §965 or do not qualify for the DRD may still be eligible for the older deemed paid FTC rules under §960. To ensure proper tax treatment, corporations must maintain accurate Earnings & Profits (E&P) schedules to distinguish between pre-and post-2018 earnings and track available credits accordingly.
Practical Implications of the Deemed Paid FTC
Double Tax Avoidance:
Without deemed paid credits, if a foreign subsidiary pays local income tax, the U.S. parent could be taxed again on the same stream of earnings, creating double taxation.
Dividend Triggers:
For older earnings or specific Subpart F/GILTI inclusions, the U.S. parent is effectively “grossing up” its income by the foreign taxes attached to that portion of the profits.
Ownership Threshold:
The 10% ownership requirement is crucial. If the U.S. parent’s stake dips below that threshold, it loses the ability to claim indirect or “deemed paid” credits altogether.
Complex Recordkeeping:
Detailed tracking of the foreign corporation’s E&P, taxes paid, distributions, and Subpart F or GILTI inclusions is essential to defend your credit calculations in an audit.
Note: Failure to maintain accurate E&P or foreign tax allocation records could result in disallowed credits and extensive deficiency assessments if the IRS or FTB challenges your computations.
Misapplication of the deemed paid credit rules can lead to:
- High-Risk IRS Audits: Redetermination of your foreign income or tax allocations can disqualify a claimed credit.
- Interest and Penalties: If the IRS finds negligence or willfulness, additional civil and criminal tax penalties, up to potential life-altering criminal tax prosecutions, could apply.
- State-Level Repercussions: California state might also adjust your state tax return if the foreign amounts were incorrectly reported or allocated.
International Taxation and How We Can Help
At the Tax Law Offices of David W. Klasing, we focus on domestic and international high-risk civil and criminal tax controversies, including nuanced international tax matters like deemed paid foreign tax credits. Our team is built around dual-licensed Attorney-CPAs who bring advanced knowledge of tax law and accounting principles to each case—precisely the blend of expertise you need to navigate the labyrinth of international tax compliance. We carefully evaluate your ownership thresholds, dividend distributions, E&P layers, and each relevant Subpart F or GILTI inclusion to ensure that all your FTC calculations and elections withstand IRS scrutiny.
Led by David W. Klasing—one of the nation’s exceptionally trained tax professionals, holding both CPA and Attorney licenses plus having earned a Master’s in Taxation—our firm places a premium on proactive planning and forthright advocacy. With an “A+” rating from the Better Business Bureau and a flawless 10.0 score from AVVO, our long track record underscores our unwavering commitment to defending and protecting clients in even the most challenging tax controversies. Whether you need immediate audit tax defense, sophisticated FTC strategies, or an in-depth review of your cross-border tax posture, our objective is clear: to safeguard your interests, minimize the risk of double taxation, and help you retain the capital you have worked hard to earn.
Don’t leave the future of your business or personal finances to chance. Contact our dual-licensed International Tax Attorneys and CPAs at Tax Law Offices of David W. Klasing at (800) 681-1295 or complete our online form here to schedule a reduced-rate initial consultation today.
