A general rule for tax planning for dividend repatriation includes cross-crediting, minimizing foreign withholding taxes and considering alternative methods of repatriating earnings.
Cross-Crediting
If a foreign corporation is operating in a high tax foreign jurisdiction, the deemed foreign tax credits are more than pre-credit U.S taxes. In this case planning should focus on reducing these excess credits.
If a foreign corporation is operating in a low-tax foreign jurisdiction it will result in a residual U.S tax. In this scenario planning should focus on reducing the residual tax.
Cross-crediting can absorb the residual tax due on dividends from highly - taxed foreign subsidiaries that are highly taxed in foreign jurisdiction.
Look through rules can make cross crediting possible with respect to dividends from foreign corporations located in low-tax and high-tax jurisdictions. The underlying earnings of the foreign corporation have to be assigned to same category of income limitation.
Example:
USAco owns 100% of both LOWco and HIGHco, two foreign corporations. At the end of current year, LOWco’s and HIGHco’s pools of post 1986 undistributed earnings and post 1986 foreign income taxes are as follows:
|
|
LOWco |
HIGHco |
|
Post 1986 undistributed attributable to general limitation |
$8 million |
$6 million |
|
Post 1986 foreign income taxes attributable to general limitation income
|
$2 million |
$9 million |
Assume U.S tax rate = 35% and dividends distributed by LOWco and HIGHco are not subject to foreign withholding taxes.
Case 1
Repatriate earnings from low-tax subsidiary:
Assume LOWco distributes a $4 milliondividends to USAco. The dividends will pull out $1 million of deemed paid taxes [$2 million of post 1986 foreign income taxes x ($ 4 million dividend / $8 million of post 1986 undistributed earnings)]. With the gross up of $1 million, USAco would have dividend income of $$5 million [$4 million dividend + $1 million gross up)]. Under the look through rule, the entire amount of this dividend and the related foreign income taxes would be assigned to general limitation income. Therefore, with in USAco’s general income limitation, there would be a limitation of $1.75 million [35% of U.S tax rate x 5 million] deemed paid taxes of $1 million, and a residual U.S tax of $750,000 [$1.75 million - $1 million]
Case 2
Repatriate earnings from both low and high-tax subsidiaries:
Every dollar of dividends from HIGHco increases the deemed paid taxes within USAco’s general income limitation by $1.50 [$9 million of post-1986 foreign income taxes x ($1 dividend / $6 million of post-1986 undistributed earnings)] and also increases USAco’s general income limitation by $0.875 [35% U.S tax rate x ($1.00 dividend / $1.50 gross up)]. The net effect is an excess credit of $0.625 for every dollar of dividends [$1.50 of additional deemed paid taxes $0.875 of additional limitation]. Therefore, USAco can completely eliminate the $750,000 residual U.S tax on LOWco’s $4 million dividend by having HIGHco distribute a dividend of $1.2 million ($1.2 million / $.0625). A $1.2 million dividend from HIGHco would pull out $1.8 million of deemed paid taxes [$9 million of post-1986 foreign income taxes x ($1.2 million dividend / $6 million of post-1986 undistributed earnings)] and increase USAco’s general limitation income by $1,050,000 [35% U.S tax rate x (@1.2 million dividend / $1.8 million gross-up)], for an additional credit of $750,000 to eliminate the residual U.S tax.
Minimizing foreign withholding taxes:
Most foreign countries impose flat rate withholding tax on gross amount of dividends paid by a locally organized corporation to its U.S shareholders. This can increase the excess credit problem created by dividends from foreign subsidiaries that operate in high tax foreign jurisdiction.
Tax treaties usually reduce the withholding tax rate to 15% or less. The treaty withholding rate is often lower for controlling shareholders. Therefore a domestic corporation can use tax treaties to reduce foreign withholding taxes. For example, by owning foreign operating subsidiaries through a foreign holding company located in a country with a favorable treaty network that contains lenient limitation of benefits article.
Alternative to dividend repatriation:
A domestic corporation can receive interest, rental, royalty payments and higher transfer prices from its foreign subsidiary. Foreign subsidiary can claim tax deductions for these payments made to its parent corporation.
Dividend distributions are not tax deductible. But it can provide the domestic parent with deemed paid tax credit.
If the foreign subsidiary is operating in a high-tax foreign jurisdiction, the benefits of a deduction at the foreign subsidiary level may exceed the costs of losing the deemed paid credit.
Example:
USAco owns 100% of ASIAco, a foreign corporation. During its first year of operations, ASIAco’s had taxable income of $10 million and made no deductible interest payments to USAco. Assume that the foreign income tax rate is 45%, the U.S rate is 35%, and no foreign withholding taxes are imposed on any dividend distribution or interest payments that ASIAco makes to USAco.
Case 1
Repatriate earnings through dividend:
If USAco repatriated all of ASIAco’s after-tax earnings through a dividend, the foreign tax on those earnings would be $4.5 million [$10 million of taxable income x 45% of foreign tax rate]. USAco would receive $5.5 million dividend distribution, which would pull out $4.5 million of deemed paid foreign taxes [$4.5 million of post-1986 foreign income taxes x ($5.5 million dividend / $5.5 million of post-1986 undistributed earnings)]. With the gross up, USAco would have dividend income of $10 million [$5.5 million dividend / $4.5 million gross up] and its pre-credit U.S tax would be $3.5 million [$10 million x 35% U.S tax rate]. There would be no residual U.S tax due on the dividend income since USAco’s deemed paid credits would offset the entire pre-credit U.S tax. In sum, if USAco repatriates ASIAco’s earnings through a dividend distribution, the total tax on those earnings would equal the foreign tax of $4.5 million.
Case 2
Repatriate earnings through interest payments:
USAco may be able to reduce the total tax burden on ASIAco’s earnings by repatriating those earnings through deductible interest payments, as opposed to dividend distributions. As an extreme example, if USAco financed ASIAco in a way that provided ASIAco with $10 million of deductible interest payments, that interest expense would reduce ASIAco’s taxable income to $0. On the other hand, USAco would owe $3.5 million of Y.S tax on interest payments it received from ASIAco [$10 million of interest income x 35% U.S rate]. Nevertheless, the total tax on ASIAco’s repatriated earnings would equal the U.S tax of $3.5 million, which is $1 million less than the total tax if ASIAco’s earnings are repatriated through a dividend distribution.
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Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.
The Accounting and Tax