From 1996 through 2014, corporations with multinational presences saw an increase in foreign income tax payments of 265 percent, and that trend continues upward. With high income tax amounts owed overseas, it pays to understand how domestic credits and deductions can save on overall tax burdens. For manufacturing companies, which earn
around 60 percent of the total domestic income reported by American corporations, the right tax savings can mean the difference between black and red on the balance sheets.
Tax Credit versus Deduction
Businesses that pay taxes on income earned internationally can often report those payments on domestic tax returns. Manufacturing firms can choose to use foreign income taxes as a deduction, which reduces the amount of domestic income that is taxable. In most cases, however, it is more financially advantageous to take the foreign income tax paid as a credit; a credit directly reduces the amount of taxes a corporation owes. One situation where a deduction might be the better choice could exist if a company's overall expenses are just shy of an exclusion point without reporting the foreign taxes as expenses.
Calculating Foreign Tax Credits
U.S. companies regardless of whether they operate in or outside of the U.S. are required to pay a 35% federal corporate tax rate on their world-wide income. In addition, they are also obligated to pay income taxes to the country in which they earned a profit. In order to avoid “double taxation” the IRS makes allowances for the taxes paid to the foreign government in the form of a foreign tax credit. According to the Tax Foundation, “to arrive at a 35 percent effective tax rate on corporate foreign earnings, the IRS affords U.S. corporations a foreign tax credit against U.S. taxes equal to the corporate taxes they paid to foreign governments. When corporations repatriate their foreign earnings, they are required to report how much income they earned in each country they operated in and how much they paid those countries in corporate income taxes. The credit U.S. corporations receive is equal to the corporate income taxes paid to foreign governments on foreign earned income that is returned to the U.S.” It is important to note that there are exclusions as to what qualifies as a tax credit: sales tax, VAT, goods and services tax, licenses or permit tax, consumption tax, or capital tax are not included. Companies do have an option to postpone payment of taxes to the IRS if the profits are used for reinvestment purposes in the foreign company. Taxes will eventually have to be paid when the profits are returned to the U.S.
In its simplest form, for example, if a manufacturing company earns $10,000 in profit, it must pay $3,500 to the IRS. If the company earns that profit in a foreign country that has a 20 percent tax rate, it is obligated to pay $2,000 in taxes to that county. The foreign tax credit allows the company to report (or in other words get a credit for) the $2,000 paid to the other nation, reducing the domestic tax liability on that income to $1,500. Therefore it fulfills its 35% taxable requirement to the IRS, even though the U.S. government is getting only a percentage of the total taxable profit.
Excluded Income Situations
If a company excludes income under other provisions of domestic tax law, it cannot claim foreign taxes paid on that income as either a deduction or a credit. The foreign tax credit is designed to alleviate double taxation; in a situation where income is excluded in a domestic tax return, no double taxation exists. This situation commonly arises when entities exclude foreign-earned income under the foreign earned income exclusion. If manufacturing firms pay for foreign housing, they might also use the foreign housing exclusion, which also reduces the ability to claim the foreign tax credit.
Common Compliance Issues
While the premise of the foreign tax credit, as described in the example above, is simple, application of the credit is not always so simple. A number of other factors come into play, creating common compliance potholes that can trip up manufacturing companies that are not careful with their tax returns. Because income taxes are not the only expense paid by manufacturing organizations, reported expenses—particularly interest expenses—must be apportioned appropriately. Likewise, some expenses—such as charitable expenses—are not reported against foreign income but are reported against domestic income. Numerous other requirements and laws might be a factor in filing, particularly for manufacturing firms that deal with inventory and machinery expenses.
How to report Foreign Taxable Income
Not every situation is as cut and dried as the above example, and foreign tax credits and income reporting requirements can become complex. Corporations generally use Form 1118 to report income that is taxable by a foreign nation. The same form is used to record the amount of taxes paid to foreign governments. In some cases, the United States may have entered into a tax treaty with the foreign nation where income was earned; some of these treaties allow for additional credits for corporations. Those credits are claimed on forms separate from Form 1118. The U.S. has such treaties with approximately 29 countries, including the United Kingdom, Germany, France, Canada, Mexico, South Africa, and Australia, but worksheets are not provided for calculating applicable tax savings. Instead, companies must apply the treaty laws to their own situation to determine the savings.
Manufacturing companies should always work with professionals to prepare forms and income tax returns to ensure all income is reported correctly and in a way that legally saves the most in tax liabilities.
For more information, contact Allan Peiser at (214) 635-2503, or one of our other experienced professionals.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.