Chapter 6 Solutions - Unit 6 FOREIGN TAX CREDIT THE 904...

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Unit 6 FOREIGN TAX CREDIT: THE § 904 LIMITATIONS A. CODE AND REGULATION PROVISIONS Code §§ 904(a)–(d)(2), (f)(1)–(3), (5). Reg. § 1.904-1(b). B. PROBLEMS FOR CLASS DISCUSSION 6-1. Jennifer, a United States citizen and resident, operates a pharmacology consulting business as a sole proprietor. In Year 1, Jennifer realized $100,000 of taxable income from Colombia, on which she paid Colombian income taxes of $45,000. Jennifer also realized $150,000 of domestic taxable income. (a) Assuming a 35 percent rate of tax is imposed by the United States, compute Jennifer’s foreign tax credit for Year 1. 1 (a) JENNIFER’S TOTAL FOREIGN TAX CREDIT IS $35,000. Jennifer’s income for Year 1 can be summarized as follows: Item Source Amount Foreign Tax Paid Foreign taxable income Colombia $100,000 $45,000 (45%) Domestic taxable income USA $150,000 None (a) Jennifer has taxable income of $250,000, yielding a tax owing to the United States of $87,500 (250,000 x 35%). Her § 904 ratio equals 40 percent ($100,000 foreign taxable income/$250,000 worldwide taxable income). When applied to her domestic tax liability of $87,500, her maximum credit amount is $35,000, which is less than the foreign taxes Jennifer paid, leaving her in an “excess credit” situation with a $10,000 credit carryover. Since the foreign tax rate (45%) exceeds the United States tax rate (35%), one would expect to find excess foreign tax credits. (b) What result if, in addition to the above transactions, she derived $50,000 of Canadian-source interest income subject to a reduced tax rate of 5 percent? Assuming she paid $2,500 in Canadian income taxes and a 35 percent rate of tax is imposed by the United States, compute Jennifer’s foreign tax credit for Year 1. (b) WITH THE ADDITIONAL EARNINGS, JENNIFER’S TOTAL FOREIGN TAX CREDIT IS $37,500. Jennifer’s income for Year 1 can be summarized as follows: Item Source Amount Foreign Tax Paid Foreign taxable income Colombia $100,000 $45,000 (45%) Domestic taxable income USA $150,000 None Foreign interest income Canada $50,000 $2,500 (5%) 1 While current income tax rates on capital gain and ordinary income for individuals are 20 percent and 39.6 percent, respectively, the problems generally assume rates of 15 percent and 35 percent, reflecting a 20 percent rate differential. 27
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(b) Without the separate basket rules, Jennifer would be advantaged by earning lightly taxed income. Her § 904 ratio would be 50 percent ($150,000 foreign taxable income/$300,000 worldwide taxable income), and her “blended” effective tax rate would be about 31.7 percent (47,500/150,000), which is below the 35 percent United States tax rate. Thus, when applied to her domestic tax liability of $105,000, her maximum credit amount would be $52,500, more than enough to cover all of the foreign taxes Jennifer paid. If she had no foreign interest income, the ratio would have been only 40 percent ($100,000 foreign taxable income/$250,000 worldwide taxable income) as seen in 6-1(a) above, her domestic tax liability (assuming a 35% rate) would have been $87,500, and the ceiling would have been $35,000, leaving her in an “excess credit” situation.
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