Maximizing Foreign Tax Credits With The Sourcing Rules

Note: This year’s CCH Connections: User Conference 2016 features 75 sessions in 7 different tracks. With so much great content, it can be hard to choose which sessions you want to attend. That’s why we’ve invited several presenters to preview some of their ideas in a series of guest posts. This post is by Robert Misey, Chair of the International Department at Reinhart Boerner Van Deuren in Milwaukee and Chicago. His session, “Reducing the Cost of Foreign Operations with Foreign Tax Credits: Completing Forms 1116 and 1118” is available in the Tax track.

The United States taxes U.S. persons on all of their income from whatever source derived.  Therefore, the source of income generally has no effect on the computation of a U.S. person’s taxable income.  Sourcing can have a significant effect, however, on the computation of a U.S. person’s foreign tax credit limitation, which is the pre‑credit U.S. tax on foreign‑source income.

The limitation prevents U.S. persons from crediting all of their foreign income taxes.  If not enough foreign‑source income exists, the foreign income taxes would exceed the limitation and those noncreditable foreign income taxes will increase the combined total of U.S. and foreign taxes.

Although it is important to understand each of the sourcing rules, many U.S. persons make mistakes with sourcing the gross profit from the sale of inventory.  Merely because a foreign country taxes a sale does not mean that the sale results in foreign‑source income.

If USCo purchases inventory for resale abroad, the gross profit is sourced by the location of title passage.  For example, if USCo passes title outside the United States (e.g., foreign customer’s loading dock), all of its gross profit is foreign‑source, which will increase the limitation.  However, if USCo passes title in the United States (e.g., USCo’s shipping dock), all of its gross profit is U.S.‑source and USCo will have a foreign tax credit limitation of zero, rendering uncreditable all the foreign income taxes that USCo pays.

As opposed to the all or nothing rule for resales of purchased inventory, the 50/50 method applies to sales of manufactured inventory.  Under the 50/50 method, a U.S. manufacturer apportions 50% of its gross profit by the location of its production assets and 50% of its gross profit by the location of title passage.  For a U.S. manufacturer, this means that half of the gross profit will always be U.S.‑source income.  The U.S. manufacturer must ensure that title passes abroad on all sales of its manufactured inventory so that at least the title passage half constitutes foreign‑source income.  These rules typically result in a U.S. manufacturer having only 50% of its gross profit characterized as foreign‑source income, rendering some foreign income taxes uncreditable, but mistakenly passing title in the United States would result in both halves of the gross profit being U.S.‑source income, rendering all foreign income taxes uncreditable.

CCH Connections 2016 will features seven different tracks, with more than 75 sessions that have been developed exclusively for CPAs to help take you and your firm to the next level. Register Today!

AUTHOR

Robert Misey

Chair of the International Department at Reinhart Boerner Van Deuren

All stories by: Robert Misey

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