USA: Understanding Section 905(c) and the Foreign Tax Credit

As tax professionals who operate in the increasingly interconnected world of international business, it is incumbent upon us to gain a thorough understanding of key tax provisions that shape the global business environment. The United States (“U.S.”) taxes U.S. taxpayers on their worldwide income. Thus, income earned outside of the U.S. (e.g., foreign source income) may be subject to tax in both the U.S. and in the source country, resulting in double taxation on the same income. The U.S. Foreign Tax Credit (“FTC”) attempts to potentially mitigate double taxation by providing a credit against the U.S. tax on foreign source income. This alert aims to provide a high-level overview of Section 905(c) of the U.S. Internal Revenue Code (“IRC”) and the concept of FTCs.

I. Understanding the FTC

The FTC is codified in IRC Sections 901-909. This non-refundable tax credit is available to U.S. taxpayers as a relief mechanism against double taxation of income taxed by a foreign jurisdiction and subject to U.S. tax. The FTC serves as a tool that prevents the undue burden of taxation that would otherwise ensue from the U.S.'s approach of taxing its residents on worldwide income. This mechanism helps foster a competitive landscape for U.S. businesses operating abroad.

To appreciate its significance, imagine a U.S. taxpayer engaging in international operations. The business is met with numerous foreign tax obligations as they enter new global markets. The U.S., meanwhile, stands ready to tax its worldwide income. This could result in the same income being taxed twice – once by the foreign jurisdiction and again by the U.S. It is here that the FTC steps in, shielding the taxpayer from the brunt of this double taxation and creating a more level playing field for U.S. businesses abroad.

 II. Overview of Section 905(c)

IRC 905(c)(1) specifies three main types of foreign tax changes that result in a foreign tax redetermination:

1. if taxes when paid or later adjusted differ from amounts accrued by the taxpayer and claimed as a credit;
2. accrued taxes that are not paid within 2 years after the close of the taxable year to which the taxes relate; or
3. refund of foreign taxes.

The inclusion of Section 905(c) in the IRC represents a legislative response to the complexities that arise in the realm of foreign taxation. Its primary function is to prescribe rules for taxpayers to follow when they experience changes to their foreign tax liabilities after the end of the tax year. These changes could result from many factors, including but not limited to changes in foreign tax laws, completion of audits by foreign tax authorities, or corrections of computational errors. Section 905(c) requires taxpayers to notify the IRS of these changes to maintain an accurate and fair reflection of the claimed FTC. The purpose is twofold: ensuring the integrity of the U.S. taxation system and allowing taxpayers to adjust their FTC claims to reflect their actual foreign tax liabilities. Section 905(c) prevents taxpayers from claiming a credit for foreign taxes paid, receiving a refund of those taxes in the foreign country, and failing to adjust their U.S. tax liability accordingly.

A foreign tax redetermination occurs when there is a change in a taxpayer’s foreign tax liability that affects the taxpayer’s previously claimed FTC. For example, a taxpayer claims an FTC in year 1 based on foreign taxes paid or accrued in that year. Subsequently in year 3, the taxpayer is audited by the foreign country and the original tax liability for year 1 either increases or decreases. This redetermination impacts the FTC claimed in year 1.

 III. Conclusion

Many U.S. tax practitioners still assume that a true-up payment can be reported as part of current year FTC reporting, but that is no longer the case. After repeal of Sec. 902 by the Tax Cuts and Jobs Act in 2017, FTCs are determined using a year-by-year calculation rather than a pooling concept (i.e., as was the case before 1986). True ups under Sec. 905(c) generally require filing an amended return. The instructions to Form 5471, Schedule E note: “adjustments to foreign income taxes paid or accrued in a prior year should not be reflected on Schedule E in the year of adjustment. Instead, they should be reported in the year to which such taxes relate. This may require an amended return.”

Companies with U.S. income tax filings and foreign subsidiaries (i.e., controlled foreign corporations for U.S. tax purposes) should closely examine their income tax filings process. A coordinated approach between the U.S. income tax and foreign income tax filings is necessary to mitigate FTC redeterminations and avoid time consuming amended returns. As we navigate the nuanced landscape of international taxation, IRC Section 905(c) and the FTC serve as critical guideposts. They not only play a pivotal role in ensuring compliance with U.S. tax laws but also aid in alleviating the potential for double taxation while fostering a more equitable international business environment. It is essential for us, as tax professionals, to appreciate and understand these mechanisms to provide strategic and compliant solutions for our clients.

Please reach out to WTS Member Firm Global Tax Management for more information on this topic