How taxpayers should deal with changes in the determination of foreign taxes due for purposes of the foreign tax credit was discussed in Chief Counsel Email 201534013. Specifically, the question arose regarding a taxpayer on the cash basis of accounting who has not elected to report the foreign tax credit on the accrual basis that faced an additional assessment of foreign tax related to a prior year.
The foreign tax credit is governed by rules found in IRC §§901-909. Under IRC §905(a) a taxpayer, even though otherwise on the cash basis for tax reporting, may elect to report foreign taxes when accrued for purposes of the foreign tax credit. The election, once made by the taxpayer, is binding for all future years.
IRC §905(c) contains provisions related to adjustments to accrued taxes. Under IRC §905(c)(1) the taxpayer must notify the IRS if any of the following events take place so that a foreign tax credit may be redetermined:
- Accrued taxes when paid differ from the amounts claimed as credits by the taxpayer
- Accrued taxes are not paid before the date 2 years after the close of the taxable year to which the credits relate or
- Any tax paid in refunded in whole or in part
The situation that is being discussed would work something like this—Mary had claimed a credit for foreign taxes paid on her 2014 return. She files, like most individuals, on the cash basis and she had not made the election under IRC §901(a) to take the foreign tax credit in the year in which the taxes accrued in either 2014 or any prior year.
She paid $500 in tax on a transaction and was able to obtain the full $500 as a credit on her federal return after all the limitations are taken into account, the principal one being the foreign income. In 2015 the foreign taxing agency determines Mary should have paid $1,000 and she therefore pays an additional $500. That $500 relates not to any foreign income she may (or may not) have in 2015, but rather to her foreign income from the earlier year.
So the question becomes—does Mary now recomputed her credit for 2014 by treating this as a tax paid in 2014 (since that is the year to which the tax relates—she simply paid an erroneous amount), or does she treat it as creditable on the 2015 return? The email concludes that because Mary had not made the election to report the foreign taxes on an accrual basis, the tax paid is to be treated as paid in 2015, and enters into the credit computations for that year.
The ruling reasons:
For a taxpayer claiming credits on the cash basis, treating additional foreign tax payments as a redetermination of foreign tax that accrued in a prior year, and allowing the taxpayer to redetermine his or her U.S. tax by claiming additional credits in the prior year, would effectively permit the taxpayer to change his or her method of accounting for foreign taxes from the cash basis to the accrual basis on an amended return, which is not permitted by the case law and administrative rulings.
However, if the foreign taxing agency had found Mary had overpaid her taxes and refunded her $250 the answer changes—in that case Mary must revise her 2014 return to reduce the claimed amount of foreign taxes paid.
In contrast, section 905(c)(1)(C) requires a redetermination of U.S. tax to reduce the foreign tax credit claimed if foreign tax paid is refunded in whole or in part. Therefore, a taxpayer claiming credits on the cash basis must file a U.S. amended return for affected years and pay the resulting U.S. tax deficiency when foreign taxes previously paid and claimed as a credit are refunded. This is because a refund, unlike an additional payment, results in a change to the cash basis foreign tax liability, i.e., a foreign tax redetermination, for the year in which the taxes were paid and claimed as a credit.