Q:  What is the effect of the ETI exclusion on foreign tax credit benefits?

A:  Under the ETI regime, businesses claiming an exclusion of gross income will lose a pro rata portion of the foreign taxes attributable to excluded income.  Under Sec. 114(d), no foreign tax credit will be allowed for amounts paid “..with respect to...” excluded ETI.  The intent was to disallow double tax benefits for QFTI: first, a portion of QFTI is excluded from the U.S. tax base under territoriality principles.  Then, the amounts on non-excluded QFTI would be eligible for a foreign tax credit benefit.  As a result, in computing foreign taxes paid during the year, taxpayers claiming the ETI exclusion will be required to reduce creditable income taxes.

An exception applies to certain withholding taxes.  Under Sec. 943(d), the reduction of foreign tax credits under Sec. 114(d) does not apply to withholding taxes attributable to excluded ETI.  A withholding tax, for purposes of this exception, is defined as a tax, which is imposed on a basis other than residence and constitutes a creditable tax under Secs. 901or 903.  An exception to the exception applies to withholding taxes paid with respect to foreign sales and lease income (FSLI), as defined under Sec. 941(c).

The reduction of foreign tax credits does apply to income taxes incurred on direct foreign sales by a U.S. business, i.e., where title passes overseas, or on manufacturing income earned by a foreign electing corporation.  Foreign corporate or branch taxes paid by a foreign check-the-box entity or branch of a U.S. company would be subject to the reduction in the event it qualifies for the ETI exclusion.

For sales subject to tax under Sec. 863(b), the ETI regime contains a limitation, or 863(b) haircut, on the amount of foreign source income eligible for foreign tax credit limitation purposes.  This “haircut”, as computed under Sec. 943(c), is based on the formulary pricing rules under the DISC regime (1972-1984), and limits the amount of foreign source income being claimed.

The statute does not provide any guidance on the computation of the amount of disallowed taxes.  The statute is clear, however, that only taxes attributable to excluded income are disallowed.  Presumably, this disallowance applies on a transaction-by-transaction basis.  For example, assume QFTI is 400 and subject to a 10% income tax, or 40.  If FTI is 200, then the amount of the exclusion is 30 (15% * 200).  As a result, the amount of foreign taxes disallowed would be 6 (30/200 *40).

Companies must review the interrelationship between the new ETI regime and their current foreign tax credit position, especially regarding foreign entities.