ODLs and Switching from Deducting to Crediting Foreign Taxes

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By Dirk J.J. Suringa, Esq.

An overall foreign loss (OFL) arises when foreign-source deductions exceed foreign-source income for the year.1 Taxpayers must keep an OFL account to track the net annual increase or decrease in their historic foreign losses,2 and an OFL is added to the account to the extent it produces a tax benefit by reducing U.S.-source taxable income.3 Future foreign-source income is recaptured as U.S.-source income, up to the amount of the OFL account.4 Recapture has the effect of reducing the foreign tax credit limitation and thus the current creditability of foreign taxes.

Taxpayers with perennial net foreign losses often deduct foreign taxes instead of claiming the foreign tax credit. If they are in a net foreign loss position, their foreign tax credit limitation is zero. If they elect to claim the foreign tax credit, therefore, the allowable credit is zero, and the credit would become an excess credit that could be carried back one year and then forward up to 10 years.5 If taxpayers in this position will not generate enough net foreign-source income within 10 years (1) to recapture their OFL account and (2) to generate enough limitation to utilize both future and carryforward credits, those carryforward credits will expire unused.

By contrast, if taxpayers in a net foreign loss position deduct foreign taxes, they can reduce currently any taxable U.S.-source income. If they have domestic losses as well, the foreign tax deduction becomes part of their NOL, which can be carried forward 20 years instead of 10. For this reason, taxpayers with perennial net foreign losses generally deduct foreign taxes.

Not all the consequences of this decision are positive, however. If they can be claimed, credits obviously provide a greater tax benefit than deductions because credits offset U.S. tax liability dollar for dollar. In addition, because taxpayers cannot elect to credit certain taxes and deduct other taxes for a single year,6 corporate taxpayers that deduct foreign taxes cannot claim an indirect foreign tax credit for the taxes paid by their CFCs. Instead, they generally must avoid taxable repatriations to the United States and work to reduce their CFCs' foreign tax exposure.

For these reasons, taxpayers that have historically incurred net foreign losses begin to consider switching from deducting to crediting their foreign taxes once they start generating positive net foreign-source income on a consistent basis. The tax law provides some flexibility on this decision. The 10-year carryforward allows taxpayers to switch before they actually have enough limitation to fully utilize their credits, in the expectation that they will have enough capacity within the next few years. Taxpayers also can use hindsight and elect retroactively for a period of up to 10 years to switch from deduction to credit (or vice-versa).7 Taxpayers earning their way out of an OFL account can use these rules to time the switch from deduction to credit and adjust or correct their timing on an ongoing basis.

Figuring out when to make the switch is relatively straightforward if the taxpayer also earns net U.S.-source income on a consistent basis. Domestic losses complicate the picture considerably, particularly after the enactment of the overall domestic loss (ODL) rules and the promulgation of implementing regulations in 2007 (the “2007 Regulations”).8 ODLs generally accelerate the year for which the switch from deduction to credit would be beneficial, with some caveats.

An ODL is created when a domestic loss offsets foreign-source income during a year in which the taxpayer claims the foreign tax credit.9 The offset year can be either the current year or a prior year by reason of a loss carryback, but it must be a year in which the taxpayer claimed the credit. If the offset occurs in the current year, the ODL is created in the current year. If the offset occurred in the carryback year, the ODL also is created in the current year. If the offset occurs in a future year, by reason of a carryforward, then the ODL is created in that future year (assuming it too is a credit year).10 The taxpayer must establish an ODL account and increase or decrease it annually. Future U.S.-source income is recaptured as foreign-source income by up to 50% of the amount of the ODL account. ODL recapture increases the foreign tax credit limitation for the recapture year. It can increase credit utilization once a taxpayer starts to have net domestic-source income.

Unlike an OFL, an ODL can be created only in a credit year. This rule may have been intended to prevent taxpayers from claiming a deduction for foreign taxes in a year when their domestic loss offset their foreign-source income and then using that same domestic loss in a later year to increase their foreign tax credit limitation for other taxes through ODL recapture. The practical effect of the rule, in any event, is to accelerate the year for which a taxpayer with domestic losses, earning its way out of its OFL, might consider switching from deduction to credit. Electing the credit in a year when all credits carry forward still could be worthwhile if the taxpayer projects that the credits will carry forward to a period when ODL recapture would enhance their utilization.

In at least two respects, however, the OFL and ODL recapture ordering rules may have the opposite effect and thus may delay the appropriate year for switching from deduction to credit. First, the ordering rule for offsetting U.S.-source losses against foreign-source income has changed. Before the 2007 Regulations, OFL recapture occurred before domestic losses offset foreign-source income.11 Thus, foreign-source income was recaptured as U.S.-source income, and that U.S.-source income could be used to absorb the domestic-source loss. This rule benefited taxpayers because it accelerated the recapture of OFL accounts while avoiding the reduction of foreign-source income by domestic-source losses. The 2007 Regulations reversed this rule. Domestic-source losses now reduce foreign-source income before OFLs are recaptured. The main reason for the reversal was the enactment of the ODL regime, which potentially creates a tax benefit from the offset of the domestic loss against foreign-source income. Nevertheless, this change may delay the switch from deduction to credit because OFL recapture will occur more slowly than under prior law.

Second, OFL recapture occurs before ODL recapture, and the two processes occur independently. 12 Thus, OFL and ODL accounts do not offset. When OFL recapture converts foreign-source income into U.S.-source income, ODL recapture does not convert it back into foreign-source income. ODL recapture applies only to whatever other U.S.-source income the taxpayer has for the year. This rule also may work to delay the appropriate year for electing to switch from deduction to credit, depending on the taxpayer's mix of domestic- and foreign-source income.

In summary, a taxpayer earning its way out of an OFL might find it beneficial to elect to switch early (or retroactively) from deducting to crediting foreign taxes if it experienced a significant — but temporary — domestic loss in 2008. The potential benefit of claiming an ODL that may later convert U.S.-source income into foreign-source income and allow greater credit utilization may outweigh the risk of expiring credits, even taking into account that OFL recapture will occur separately from ODL recapture. The problem of accurate profit forecasts can be mitigated to a degree by the ability to switch retroactively up to 10 years. The ability to elect retroactively also may be worth another look if some of the legislative proposals currently under discussion move forward.

This commentary also will appear in the December 2009 issue of theTax Management International Journal. For more information, in the Tax Management Portfolios, see Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.
1 §904(f)(2).
2 See Regs. §1.904(f)-1(b).
3 Regs. §1.904(f)-1(d).
4 SeeRegs. §1.904(f)-2T(c)(1).
5 §904(c).
6 §275(a)(4).
7 SeeRegs. §1.901-1(d).
8 T.D. 9371, 72 Fed. Reg. 72592 (12/21/07).
9 §904(g)(2); Regs. §1.904(g)-1T(c).
10 See Regs. §1.904(g)-1T(b)(2).
11 See Notice 89-3, 1989-1 C.B. 623, §5.
12 See Regs. §1.904(g)-3T(e)-(g).