HTKO (High-Tax Kick Out) & Foreign Tax Credits

HTKO (High-Tax Kick Out) & Foreign Tax Credits

What is HTKO?

HTKO: The High-Tax Kickout Rules are referred to as HTKO, and they can be a very complicated IRS International Tax exercise. With the High-Tax Kickout, foreign investment income that would ordinarily qualify for foreign tax credit treatment is shifted into the general category. The reason the IRS limits the use of high-taxed foreign income, is to ensure that the foreign income does not result in reducing the U.S. tax liability of the filer. In other words, foreign tax credits cannot be used to reduce U.S. tax on U.S. income, or artificially reduce other foreign income that benefits from the high tax rate of the foreign income.

HTKO (High-Tax Kick Out) & Foreign Tax Credits

When a Taxpayer wants to claim a Foreign Tax Credit, they use IRS Form 1116 to claim the credit.

For example, Marissa earns $24,000 USD equivalent of foreign interest income and she paid $6,000 of tax overseas. Marissa will file a Form 1116 to claim the Foreign Tax Credit.

But, what happens if Marissa paid $18,000 in taxes abroad?

Is this High-Taxed Income?

Yes.

Why?

Because Marissa paid 75% tax on the income she earned overseas. The 75% tax rate is far beyond the tax rate for U.S. on the same income (37%).

As provided by the IRS:

Passive income doesn’t include export financing interest, active business rents and royalties, or high-taxed income.

High-taxed income is income if the foreign taxes you paid on the income (after allocation of expenses) exceed the highest U.S. tax that can be imposed on the income.

What Happens to HTKO?

When income is HTKO, it cannot be applied as foreign tax credit on the passive income it was paid for in the foreign country. Instead, it shifts over the general income category.

Separate the Income on Form 1116

As provided by the IRS:

“If you have passive income that is high-taxed income, use a separate column in Part I. Enter “HTKO” on line i of Forms 1116 for passive category income and the other category of income to which such passive category income is reclassified.”

“High-taxed income. On your Form 1116 for passive category income, passive income that is treated as another category of income because it is high taxed should be included on line 1a in the column for the country entered on line i.

Also, enter the high-taxed income in the “HTKO” column on line 1a as a negative number. On your Form 1116 for the other category of income, the high-taxed income should be entered as a positive number on line 1a in the “HTKO” column.”

Don’t enter any amounts on lines 2 through 5 for your HTKO column.

Add all deductions that are definitely related or apportioned to passive income that is treated as another category of income because it is high taxed and enter the total amount of those deductions on line 6 in the HTKO column.

Enter the amount as a negative number on your Form 1116 for passive category income. Enter the amount as a positive number on your Form 1116 for the other category of income.”

When you look at page 1 of the 1116, you will find that there are separate columns for each country. When you have HTKO, it will receive its own column.

Adjust the Foreign Taxes for HTKO

When the taxpayer has foreign income tax that is HTKO, adjustments must be made to account for the income:

“You must adjust the foreign taxes paid or accrued if they relate to passive income that is treated as other category income because it is high taxed.

On your Form 1116 for passive category income, enter as a negative number (in parentheses) the amount of your foreign taxes that relate to that income.

On your Form 1116 for the other category income, enter as a positive number the amount of foreign taxes that relate to that income.”

Kicked-Out Foreign Passive Income

The high-taxed income is re-categorized as general category income.

IRC 904 & 26 CFR § 1.904-4 – Separate application 

To better understand the origination of the high-tax kick out, it is important understand some of the applicable code sections.

IRC 904

“(a) Limitation

The total amount of the credit taken under section 901(a) shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer’s taxable income from sources without the United States (but not in excess of the taxpayer’s entire taxable income) bears to his entire taxable income for the same taxable year.

(F) High-taxed income

The term “high-taxed income” means any income which (but for this subparagraph) would be passive income if the sum of—

(i) the foreign income taxes paid or accrued by the taxpayer with respect to such income, and

(ii) the foreign income taxes deemed paid by the taxpayer with respect to such income under section 902 1 or 960, exceeds the highest rate of tax specified in section 1 or 11 (whichever applies) multiplied by the amount of such income (determined with regard to section 78).

For purposes of the preceding sentence, the term “foreign income taxes” means any income, war profits, or excess profits tax imposed by any foreign country or possession of the United States.”

26 CFR 1.904-4: Regulation with Examples

In general, regulations are wonderful for taxpayers, because they breakdown the rules and oftentimes will also include examples.

“(c) High-taxed income

“(1) In general.

Income received or accrued by a United States person that would otherwise be passive income is not treated as passive income if the income is determined to be high-taxed income. Income is considered to be high-taxed income if, after allocating expenses, losses, and other deductions of the United States person to that income under paragraph (c)(2) of this section, the sum of the foreign income taxes paid or accrued, and deemed paid under section 960, by the United States person with respect to such income (reduced by any portion of such taxes for which a credit is not allowed) exceeds the highest rate of tax specified in section 1 or 11, whichever applies (and with reference to section 15 if applicable), multiplied by the amount of such income (including the amount treated as a dividend under section 78).

If, after application of this paragraph (c), income that would otherwise be passive income is determined to be high-taxed income, the income is treated as general category income, foreign branch category income, section 951A category income, or income in a specified separate category, as determined under the rules of this section, and any taxes imposed on that income are considered related to the same separate category of income under § 1.904-6.

If, after application of this paragraph (c), passive income is zero or less than zero, any taxes imposed on the passive income are considered related to the same separate category of income to which the passive income (if not reduced to zero or less than zero) would have been assigned had the income been treated as high-taxed income (general category, foreign branch category, section 951A category, or a specified separate category). For additional rules regarding losses related to passive income, see paragraph (c)(2) of this section.

Income and taxes shall be translated at the appropriate rates, as determined under sections 986, 987 and 989 and the regulations under those sections, before application of this paragraph (c). For purposes of allocating taxes to groups of income, United States source passive income is treated as any other passive income. In making the determination whether income is high-taxed, however, only foreign source income, as determined under United States tax principles, is relevant.”

IRS Regulations, Example 10 (Individual)

(x) Example 10.

In Year 1, P, a U.S. citizen with a tax home in Country X, earns the following items of gross income:

Income

  • $400x of foreign source, passive interest income not subject to foreign withholding tax but subject to Country X income tax of $100x,
  • $200x of foreign source, passive royalty income subject to a 5% foreign withholding tax (foreign tax paid is $10x),
  • $1,300x of foreign source, passive rental income subject to a 25% foreign withholding tax (foreign tax paid is $325x),
  • $500x of foreign source, general category loss, and
  • $2,000x of U.S. source capital gain that is not subject to any foreign tax.

Expenses

  • P has a $900x deduction allocable to its passive rental income.
  • P’s only other deduction is a $700x capital loss on the sale of stock that is allocated to foreign source passive category income under § 1.865-2(a)(3)

Foreign Income Types

In reviewing the example at the outset, the income issue that sticks out should the passive rental income. 

Why?

Because not only is it being taxed at 25%, but there is also a $900 deduction, which will significantly reduce the taxable income.

When the reduced rental income is taxed, it will presumably be at a higher tax rate than allowable in the U.S. on that income.

How are Expenses & Losses Allocated?

“The $700x capital loss is initially allocated to the group of passive income described in paragraph (c)(3)(iv) of this section (passive income subject to no withholding tax but subject to foreign tax other than withholding tax).

This group comprises the

  • $400x of interest income not subject to foreign withholding tax but subject to Country X income tax.

Under paragraph (c)(2)(ii) of this section, the $300x amount by which the capital loss exceeds the income in the group must be reallocated to the net income in the other groups described in paragraph (c)(3) of this section, but the $500x general category separate limitation loss is not allocated until the high-tax kickout rules are applied to determine whether the passive income is high-taxed income.”

In other words, the $700 is applied first to the $400 of interest, bringing the $400 to zero.

Then the remaining $300 is applied to the other categories, but not yet the general income category (which is where HTKO will land at the end of the analysis).

In Plain English

The $700 capital loss is applied to the category involving passive interest income, and the remaining $300 is applied to the other categories, except the general category.

Royalty Income

The $200x of royalty income subject to a 5% withholding tax is described in paragraph (c)(3)(i) of this section (passive income that is subject to a withholding tax of less than 15%, but greater than zero).

Rental Income

P’s $1,300x of rental income subject to a 25% withholding tax is described in paragraph (c)(3)(ii) of this section (passive income that is subject to a withholding tax of 15% or greater).

The $1,300x of rental income is reduced by the $900x deduction allocable to such income.

Therefore, the total net income in the other groups under paragraph (c)(3) is $600x,

  • $200x of royalty income; and
  • $400x of rental income.

How is the remaining $300 Capital Loss Applied?

  • The ($300x) net loss in the net basis tax group thus reduces the royalty income by $100x to $100x
    • ($200x − ($300x × (200x/600x))) and the rental income by $200x to $200x ($400x − ($300x × (400x/600x))).

Another way to visualize it:

  • The $300 leftover loss is applied proportionately to the $600 of the other category income. 
  • Since the royalty income is 1/3 of the 600, then 1/3 of the $300 capital loss is applied to it ($100).
  • Since the rental income (after deductions applied dropping it from $1300-$900 = $400) income is 2/3 of the $600, then 2/3 of the $300 capital loss is applied to it ($200).

How is the Foreign Income Taxed?

  • The $100x of net royalty income is not high-taxed and remains passive category income because the foreign taxes of $10x do not exceed the highest U.S. rate of tax on that income, which is 37% for individuals ($10x < $37x (37% × $100x)).
  • Under the high-tax kickout, the $200x of rental income and the $325x of associated foreign tax are assigned to the general category.

Let’s take another look at how we got there:

Income

  • $400x of foreign source, passive interest income not subject to foreign withholding tax but subject to Country X income tax of $100x,
  • $200x of foreign source, passive royalty income subject to a 5% foreign withholding tax (foreign tax paid is $10x),
  • $1,300x of foreign source, passive rental income subject to a 25% foreign withholding tax (foreign tax paid is $325x),
  • $500x of foreign source, general category loss, and
  • $2,000x of U.S. source capital gain that is not subject to any foreign tax.

Expenses

  • P has a $900x deduction allocable to its passive rental income.
  • P’s only other deduction is a $700x capital loss on the sale of stock that is allocated to foreign source passive category income under § 1.865-2(a)(3)

We start with the Capital Loss of $700.

  • We apply it to the similar foreign income (Passive Interest Income).
    • This reduces the $400 to zero.
  • Next, the remaining $300 is applied to other (applicable) categories:
    • $200 Passive Royalty Income
    • $400 Real Estate
      •  $1,300 reduced to $400 ($900 of direct real estate deductions applied)
  • The $300 of remaining capital loss is apportioned in relation to the remaining passive income categories
    • $200/$600 = 1/3 = $100 of the $300
    • $400/$600 = 2/3 = $200 of the $300

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